Are QE2’s many critics all wet?
The naysayers have been out in force since last Wednesday, when the Federal Reserve pledged to buy $600 billion worth of Treasury bonds in a bid to boost demand for goods and services and cut unemployment. The cold-eyed consensus is that Ben Bernanke’s second round of quantitative easing won’t get the domestic economy going and may well tip the rest of the world toward an uncontrollable, commodity-led boom followed by a wrenching bust.
But one forecaster who has a tiptop record of predicting economic twists and turns says writing off QE2 before it even gets up a full head of steam is a mistake – one that ignores the documented success of an analogous policy to boot.
Paul Kasriel, the Northern Trust economist who called housing a bubble in 2004 and was among the few in 2007 to predict a recession, says Bernanke’s easing strategy could well keep the economic recovery, such as it is, rolling along. He says critics who doubt the policy are underestimating the impact of a healing banking sector.
Bernanke skeptics say QE2’s main effect is to add liquidity to an economy already awash in the stuff. Banks are holding almost $1 trillion in reserves with the Fed rather than lending to an economy chock full of downsizing businesses and deleveraging consumers. Leading this horse to an even bigger body of water isn’t apt to make it start slurping, the thinking goes.
In support of this hypothesis the anti-QE crowd points to the failure of the economy to reverse its job-shedding course during the first run of quantitative easing, between March 2009 and 2010.
But Kasriel says this analysis conveniently ignores the crucial role of bank credit creation in funding the economy’s expansion. The reason QE1 didn’t catch the breeze even as the Fed spent $1.75 trillion on Treasury debt and mortgage bonds, he contends, is that troubled banks were slashing their balance sheets so deeply that the best the Fed could hope for was to keep the economy from coming to a complete halt.
“Commercial banking system credit contracted by a net $875 billion in the 16 months of the Fed’s first round of quantitative easing,” he writes. “Thus, when we sum the net change in Federal Reserve credit and commercial banking system credit in the 16 months ended March 2010, the period encompassing the Fed’s first round of quantitative easing, we find that the net change in credit was minus $675 billion. Is it any wonder, then, why the response of nominal GDP growth was so restrained to QE1?”
Perhaps not. But can we expect the banks to do better this time? The likes of Bank of America and Wells Fargo are, after all, accused from various angles of keeping dodgy books and facing massive legal problems via the foreclosure follies. They are facing pressure from regulators here and in sunny Basel, Switzerland, to hold more capital and reduce risk. It is certainly plausible they could soon return to their shrinking act.
But Kasriel sets the bar low, noting that all the banks would need to do to make QE2 work is to hold their balance sheets steady, rather than letting them contract sharply as they did before. And there is some evidence they may be able to do that: He notes that the contraction of commercial bank credit slowed to a relative trickle in the six months ended in September. Over the summer months, bank credit actually expanded slightly, he adds (see graph, right). The Fed’s latest reading on that statistic is due out Friday afternoon in the weekly H.8 report.
And just for good measure, Kasriel adds in a note to clients this week that, contrary to Japan-obsessed popular belief, there is evidence of QE working — though it wasn’t the Fed that pulled it off. Kasriel says the Treasury’s 1933 decision to devalue gold had the same effect as a QE sort of approach, by creating money that can be spent without yanking it directly out of someone else’s pocket.
“The upward revaluation of the Treasury’s gold holdings starting in the second half of 1933 was similar to today’s Federal Reserve purchases of securities,” he writes. “The upward revaluation of the Treasury’s gold holdings starting in the second half of 1933 increased the supply of money in the economy just as would have occurred if the Fed and the commercial banking system had increased their credit creation.”
None of this ensures smooth sailing for QE2, obviously. But perhaps those who reflexively dismiss Bernanke’s efforts haven’t won the day just yet.
“Different times and different magnitudes,” Kasriel writes of the 1933 analog. “But if the quantitative easing of the mid 1930s worked to stimulate nominal GDP, why wouldn’t the recently-announced quantitative easing by the Fed work similarly, assuming the Fed puts enough zeroes into the program?”