Quantitative Easing (QE), changes in global liquidity and financial instability

New paper by Esteban Pérez. From the abstract:

This paper argues that QE led to significant changes in the global financial system, which, are not conducive to greater financial stability. Through a policy of reserve accumulation, QE disconnected base money from the money supply and deposits from loans. Jointly with the deleveraging process of global banks, QE contributed to restrain the supply of bank credit growth throughout the world. Also global banks continued to expand their trading on the basis of opaque instruments such as derivatives. Moreover, by altering the relative profitability of investing in different assets, QE exerted a positive effect on the performance of the international bond market. This not only spilled into emerging market economies expanding the debt of both the financial sector and the non-financial corporate sector but also has reinforced the role of the asset management industry in financial markets. Due to its concentration and interconnectedness, illiquidity, and pro-cyclicality the asset management industry poses important risks to financial stability.

Read full paper here. 

Latin American Corner: Quantitative easing, commodities, corporate debt and the paradox of debt

By Naked Keynes (Guest Blogger)

The policy of quantitative easing (QE) pursued by the Federal Reserve following the fall of Lehman Brothers in September 2008 meant to lower long-term interest rates in the United States and boost expenditure had major effects on developing economies including in those of Latin America. As it is well know QE did not increase liquidity. The liquidity with which the Federal Reserve bought financial assets ended as excess reserves at the Federal Reserve balance sheet and the money multiplier became, actually a divisor (the money multiplier dropped below 1 after the start of QE).

However, quantitative easing had an important portfolio rebalancing effect, which altered the relative profitabilities of different assets and made commodities an attractive investment and speculative alternative. Investing in commodities as a way to hedge risk was also championed by mainstream economists. Gorton and Rouwenhorst (2004) (here) argued that commodities and stocks yield similar returns over time so that they are adequate investment substitutes. Moreover they claimed that commodities and stocks are, in terms of levels and volatilities, either not correlated or negatively correlated over time so that investing a part of the portfolio in commodities lowers its total risk. The effect of the boom in commodities during the 2000s in Latin America is reflected in the difference between GDP and gross domestic income (GDI) (the latter is equal to GDP plus the effects of the term-of-trade which were clearly favorable in many Latin American economies. See figure 1 below for a comparison of GDP and GDI for major Latin American commodity exporters.

This gave a false sense of prosperity that even endured after GDP growth in most economies of the region began to decline in 2011: domestic income follows GDP but with a lag).

Moreover, the increase in commodities and terms-of-trade was accompanied by nominal and real exchange rate appreciation in the great majority of Latin American countries. The appreciation in the exchange rate was detrimental to export diversification but, nonetheless, welcome by policy makers as it permitted to control inflation.

Low external interest rates, high commodity prices and income, and exchange rate appreciation set the stage for the large rise observed in the corporate debt following the Global Financial Crisis (2008-2009) in the larger economies of the region. The issuance of corporate debt involved some of the major firms in the region and major commodity producing firms as well the financial sector.

According to recent estimates (here) corporate bond issuance in foreign currency increased from US$ 170 to 383 billion dollars between 2010 and 2015 (compare with FDI figures which are of the order of US$ 150-160 billion per year). But these corporate debt estimates are flows. The corporate debt stocks are much higher. Available non-official figures for Brazil point to a corporate debt stock of US$ 300 billion dollars. The corporate debt issue not only affects Latin America but in general the developing world. According to a research note published by the Institute of International Finance (IIF, June 1 2015), the stock of corporate debt outstanding was above US$ 6.8 trillion in 2014.

The decline in commodity prices which began in 2011 and turned into an outright crash in 2015 was accompanied by exchange rate depreciation and lower growth. The decline in commodity prices reduced the income flows of tradable sector firms giving rise to a wedge between income flows and debt flows. In the case of the non-tradable sectors, the decline commodity prices plus exchange rate depreciation had both income flows and balance sheet effects. Firms have reacted by reducing the debt issuance and slash capital expenditure which affects negatively investment and growth.

As argued by Fitch “the refinancing risk is high and default risk in climbing” (Fitch Latin American Corporate Bond maturities, February 8, 2016). Moreover, as firms have tried to cut investment, this has affected profits so that the corporate sector has increased its debt instead of deleveraging. This paradox of debt, prevalent in part of the Post Keynesian literature (See, M. Lavoie, New Foundations of Post Keynesian Economics, 2014) can be illustrated in figure 2 above with the case of Chile and may be a major stumbling block to overcome the current slowdown of some of the major Latin American economies.

The Central Bank as sugar daddy

Complex technical stuff indeed

Pascal Blanqué and Amin Rajan complain about unconventional monetary policy, low or negative rates and Quantitative Easing, which they mostly blame on Greenspan and the excessive reliance on the lender of last resort (LOLR) function of the central banks (even though this precedes Greenspan). They say:

The US example shows all too clearly that the longer such unconventional policy remains in place, the harder it is to exit. Most likely, ultra-low rates will remain a fact of life for the foreseeable future, with no return to a scenario in which asset prices mostly reflect their intrinsic worth... Negative interest rates are a dangerous comfort blanket. They show that the proverbial punch bowl will continue to be replenished while the party is on. Investing is now mostly about second guessing the central banks’ next move, which even central banks themselves are not sure about.

I have a more benign view of unconventional monetary policy. It is there to support expansionary fiscal policy. But that has been like waiting for Godot. What the US example really shows is that, in the absence of significant fiscal expansion, monetary policy is not sufficient to get the economy out of the hole. You need to use the low rates, which allow government to borrow on the cheap, and boost public investment. Infrastructure spending used to be a no brainer.

So the problem is not the central bank as a sugar daddy, but the stagnation policy which results from a consensus that budgets have to be balanced, and spending reduced. The legacy of almost four decades of conservative economics, which, by the way, has been accepted by too many left of center parties.

Blanchard on rethinking macroeconomic policy

Here is Blanchard's summary of the last conference. Nothing much happening in all fairness, and certainly little impact on the policy advice that the IMF provides. On regulation, perhaps higher reserves is Blanchard's solution, and on monetary policy a higher target (which he does not discuss this time) and perhaps a defense of QE. But he only asks whether "the Fed [should] return to intervening only at the short end of the yield curve, or are there good reasons for continuing to intervene along the curve?" No mention that intervening at the long end provides space for expansionary fiscal policy by reducing interest rates (the real reason for QE).

On fiscal policy the same. There is an admission that, contrary to Reinhart and Rogoff, there is no threshold above which debt-to-GDP hurts economic growth. The discussion of the debt-to-GDP ratio has vanished from the last WEO (Apr. 2015). This is good, since in the previous one (Oct., 2014) the IMF still argued that: "many advanced economies have little fiscal space available given still-high debt-to-GDP ratios and the need for further consolidation." Blanchard repeats the language of the last WEO. He says:

"But how to assess what the right goal is for each country? This remains to be done. It has become clear that there is no magic debt-to-GDP number. Depending on the distribution of future growth rates and interest rates, on the extent of implicit and explicit contingent liabilities, one country’s high debt may well be sustainable, while another's low debt may not. Conceptually and analytically, the right tool is a stochastic debt sustainability analysis (something we already use at the IMF when designing programmes). The task of translating this into simple, understandable goals remains to be done."

Interestingly, the policy advice remains the same. For example, on Japan the last WEO says that: "risks to public debt sustainability remain a key concern given high public debt ratios, and a credible medium-term strategy for fiscal adjustment with specific measures is urgently needed to maintain market confidence." And for the US: "the priority remains to agree on a credible medium-term fiscal consolidation plan to prepare for rising aging-related fiscal costs; this plan will need to include higher tax revenue." In Europe, you ask? Well, for the IMF: "in a number of countries, elevated public debt and high fiscal deficits highlight the need for fiscal consolidation." And with lower oil prices: "most oil exporters need to recalibrate their medium-term fiscal consolidation plans." So oil importers might have more fiscal space, wouldn't they? But WEO tells us that: "continued fiscal consolidation, steady implementation of reforms, and external financing are needed to maintain macroeconomic stability" in those countries too. Wait, who doesn't need fiscal consolidation according to Blanchard and his WEO report?

If there is no magic number, they found a loophole and are arguing for a magic range it seems. Whatever the situation fiscal consolidation seems to be a solution. Given that Blanchard's conference is about rethinking policy, not theory, which presumably is doing fine, shouldn't one expect some change in policy advice?

Robin Hahnel on the Fed & the pressure to raise interest rates

From The Real News Network

Translating from Fed speak, Janet Yellen is doing everything within her power to slow down the pressure that she's under to start raising interest rates here in the United States. We actually have a news network that today sort of asked the question, is Janet Yellen too socialist? And I think that's actually a good way for people to sort of understand what's going on. As much as any chairperson of the Federal Reserve Bank of the United States can be, she is actually trying the best she can to act in the interests of the general public, which is quite unusual. And so she is trying to delay as long as possible raising interest rates in the United States, mostly because she doesn't want to derail the sort of slow and tepid recovery that's going on and she understands that raising interest rates prematurely and too rapidly would have the significant danger that it would slow our recovery. And she's pointing out that there is no sign that there is inflation on the horizon, that the only reason the Fed should have to be raising interest rates really is if there is inflationary pressure and if there is a danger of inflation. And the people trying to convince the Fed to raise interest rates keeps claiming that we need to do this to prevent inflation, but they have no evidence on that side.

Originally posted here, with full transcript. Video below.

Kevin P. Gallagher On The Fed, Emerging Markets, & Role of The Dollar

By Kevin P. Gallagher

From Foreign Policy Magazine

Emerging-market and developing countries resented U.S. Federal Reserve Chair Ben Bernanke during his spell in office. In 2012, Brazilian President Dilma Rousseff scolded Bernanke and the Fed's loose monetary policy for creating a "tsunami" of financial flows to emerging markets that was appreciating currencies, causing asset bubbles, and exporting financial instability to the developing world. It may just turn out that they dislike Janet Yellen even more.Although it was Bernanke who started tapering the Fed's loose policy, Yellen will be the one to end quantitative easing and, eventually, raise short-term interest rates. And those could be an even bigger problem for emerging markets than the initial tsunami.Yellen's recent confirmation that quantitative easing (QE) will cease in October 2014 is the latest and firmest signal that U.S. monetary policy is reversing direction. The Fed began the year talking about the "tapering" of loose monetary policy, relaxing QE's bond-buying program and potentially raising interest rates. Now a concrete end to QE is on the horizon. The big question that emerging markets are now asking is how quickly and how suddenly interest rates will go up. Following the latest numbers that the United States' GDP grew by 4 percent during the second quarter, some monetary policy hawks are calling for interest-rate hikes soon to cool the economy. That's exactly what emerging markets are worried about....

Read rest here.

And for more on the role of the dollar in the world economy see here, here, and here

Palley and the case for asset based reserve requirements

Revised paper by Tom Palley available here. From the abstract:

This paper critiques the Federal Reserve’s quantitative easing (QE) exit strategy which aims to deactivate excess liquidity via higher interest rates on reserves. That is equivalent to giving banks a tax cut at the public’s expense. It also risks domestic and international financial market turmoil. The paper proposes an alternative exit strategy based on ABRR which avoids the adverse fiscal and financial market impacts of higher interest rates. ABRR also increase the number of monetary policy instruments which can permanently improve policy. This is especially beneficial for euro zone countries. Furthermore, ABRR yield fiscal benefits via increased seignorage and can shrink a financial sector that is too large.

Read more here. Jane D'Arista has also made the case of ABRR, for example here.

Jane D'Arista - Tapering of Quantitative Easing Is Throwing Emerging Markets into Chaos

From The Real News Network

Emerging markets have been reeling since the beginning of the new year. The currencies and stock markets of Argentina, South Africa, Turkey, among other countries, have declined substantially, prompting their central banks to increase interest rates to stem the outflow of capital. The emerging-market rout, the worst start to a year on record, is widely believed to be related to the winding down of the U.S. Federal Reserve's quantitative easing program.Now joining us to discuss this is Jane D'Arista. She's a research associate with the Political Economy Research Institute, or PERI, at the University of Massachusetts, Amherst, where she also cofounded an economist committee for financial reform called SAFER, or Stable, Accountable, Fair and Efficient Financial Reform.

See here

Dean Baker on The Checkered Past of Ben Bernanke

By Dean Baker

The retrospectives of Ben Bernanke on his leaving the Fed seem to be coming in overly positive. While there is much that is positive about his tenure as Fed chair, many of these accounts have a rather selective view of history.
The part that is clearly wrong is treating Bernanke as a bookish academic who got plucked down in the middle of a financial crisis that was not his making. While Bernanke had a distinguished academic career, he had been in the middle of the action in Washington since 2002. That was when he was selected to be a governor of the Fed. He served as a governor at Greenspan’s side until he went to serve as head of President Bush’s Council of Economic Advisers in June of 2005. After a brief stint as the chief economist in the Bush administration he returned to take over as chair of the Fed in January of 2006.
It was during the period that Bernanke was at the Fed and his tenure in the Bush administration that the housing bubble grew to such dangerous levels. While Bernanke does not deserve as much blame for this as Greenspan, there were few people better positioned to try to deflate the housing bubble before it posed such a large risk to the economy. During this time Bernanke was dismissive of suggestions that the unprecedented run-up in house prices posed any problem. There is no evidence that he dissented in any important way from Greenspan’s view that the Fed need not be concerned about the housing bubble or the innovations in the financial industry that was supporting it.

Read rest here

Polly Cleveland: What’s Crippling the Recovery–Lack of Investment Demand or Too-Big-to-Lend Banks?

By Polly Cleveland

Under incoming Federal Reserve Chair Janet Yellen, the United States Federal Reserve Bank will begin to “taper” its program of “Quantitative Easing” or “QE”. Under QE, the Fed every month buys billions of U.S. Treasury bonds and other Federal securities from the big banks. QE keeps down longer-term interest rates, which will, it is hoped, encourage investment and stimulate the economy. QE has indeed supplied the biggest banks with cheap money for profitable trading in the international financial markets, enabling them to recover from the 2008 crisis—and continue paying big bonuses. It has in fact kept interest rates near zero for big banks and corporations. By purchasing bonds from the “government-sponsored enterprises”, Fannie Mae and Freddie Mac, which buy high-quality mortgages, QE has kept mortgage rates down and hence values up for prime real estate. That’s nice if you qualify, or if you’re a bank holding real estate collateral. By keeping bond yields very low, QE has also sent investors piling into the stock market looking for better returns, creating a stock market boom—nice if you own or issue stocks. So QE has done quite well for big bank executives and other members of the One Percent.

Read the rest here

Art Laffer: "I Was Wrong About Inflation." No Kidding!

Arthur Laffer said that: "Usually when you find the model this far off, you've probably got something wrong with the model, not that the world has changed... inflation does not appear to be monetary base driven." For the whole story go here.

PS: For an heterodox analysis of money and inflation, see here.

Krugman is right: "Macroeconomics is all wrong"

Krugman seems to be surprised to find out that there is no direct relation between fiscal deficits and higher interest rates, and that for the most part the relation seems to be upside down. He gets everything right, including the bold claim that mainstream macro [the only one he acknowledges, even though he knows better] is all wrong. And seriously why is he surprised that crowding out does not hold water?!

It's not new that the evidence for crowding out is weak, at best. For the most part the evidence on the positive effects of fiscal policy on the level of activity has been well established (see here Eisner, and here a review by Arestis and Sawyer). Note that essentially the surprise comes from the fact that Krugman does accept the natural rate (for more on this go here).

In that case, conventional wisdom says that it must be true that if the level of output is above its natural level (or the actual unemployment rate is below the natural, or, finally, the rate of interest is below the natural) then prices would increase and eventually credit would contract (as bank reserves decrease, or as the real balances fall) leading to a higher rate of interest. The monetary rate of interest would approach the natural. So, if the evidence for that is not there, shouldn't Krugman, like Keynes [when shown that real wages were pro-cyclical he abandoned the notion of a marginal decreasing schedule demand for labor] revise his views?

Further, if one accepts the notion of endogenous money (or MMT) then it cannot be assumed that successful fiscal adjustment (lower deficits) will lead to lower interest rates, since those rates are managed by monetary authorities. Yes the Fed normally manages the short-term rates, but the long-term ones usually follow (only before recessions, and for a short while, yield curves becomes downward sloping). And if necessary the Fed can directly intervene on long rates, as it did during the Great Depression and WW-II, and now with QE.

At any rate, some more evidence that supports the notion that fiscal expansion does not affect interest rates according to what the mainstream would suggest. Below the relation of interest rates and, instead of using fiscal deficits, public debt (source here).

As you can see there does not seem to be a relation between higher public debt and higher rates of interest. In fact, most of the time the relation goes in the wrong direction. Yes, Krugman is right, macro is all wrong, and he should abandon his model, which would be the only coherent thing to do.