End of QE? Don’t Buy It

Published June 27, 2013

A new meme is spreading in financial markets: The Fed is about to turn off the monetary spigot.

U.S. Printmaster General (aka Federal Reserve Chairman) Ben Bernanke announced he might start reducing the monthly debt monetization program, called ‘quantitative easing’ (QE), as early as the autumn of 2013, and maybe stop it entirely by the middle of next year.

He reassured markets the Fed would keep the key policy rate (the Fed Funds rate) near zero all the way into 2015. Still, the end of QE is seen as the beginning of the end of super-easy money and potentially the first move toward normalization—as if anybody still had any idea of what ‘normal’ is.

Fearing the flow of nourishing mother’s milk from the Fed could dry up, a resolutely unweaned Wall Street threw a hissy fit.

So far, so good. There is only one problem: It won’t happen.

Distorts, Sabotages, Prohibits

I would gladly be the first to declare that the Fed should abolish QE, and not only in the autumn of this year or the summer of next, but right now. Pronto. Why? Because a policy of QE and zero interest rates is complete madness. It distorts markets, sabotages the liquidation of imbalances, prohibits the correct pricing of risk, and encourages renewed debt accumulation. It numbs the market’s healing powers by enabling more “pretend and extend” in the financial industry, and it adds new imbalances to the old ones that it also helps to maintain.

This policy may have prevented—for now—debt deflation, but maybe debt deflation is what is needed.

QE is nothing but heavy-handed market intervention. It is destructive. It doesn’t solve the underlying problems. It creates new ones.

Fed’s Deceptive Metaphors

However, none of these objections even register at the Fed. The Fed has a completely different perspective: This policy was a roaring success and as it has worked so well it can now be faded out. Soon there will be no need for it. Larry Summers’s dreadful phrase captures that thinking probably best: The economy will soon have achieved “escape velocity.”

Most analogies are somewhat poor, but this one is particularly inept. Ironically, though, the reference to mechanics captures beautifully the logic of Keynesians and other interventionists: The economy is like a physical object moving through space and is occasionally in need of a little push to get moving again at an appropriate speed. Policy provides the push.

Bernanke doesn’t use these terms, but his thinking is similar. He explained QE to the American public in 2010 by announcing his job was to occasionally manipulate interest rates and asset prices to encourage lending, borrowing, spending, shopping, and other healthy economic activities, and once his machinations had stimulated enough of those activities, the economy would again enter a virtuous cycle (his words) of self-sustained growth. Escape velocity has been restored.

Economics, Not Mechanics

I think this is nonsense, however appealing it may sound to many lay persons. The economy is not an object that needs a push, or a machine that needs to be jumpstarted, or a lazy mule that needs a gentle slap on its behind to get going again. The economy is a complex process of coordination, an elaborate tool that allows an extensive and diverse group of actors with different and frequently conflicting goals and interests to cooperate with one another peacefully toward the best possible realization of their own material aims.

A crisis is a failure of that coordination process. It is a cluster of errors. The only explanation for the occurrence of such a cluster of errors is a systematic distortion of the market’s coordinating properties, such as occurs when monetary expansion distorts interest rates and other relative prices and thereby leads to imbalances that unhinge the economy.

The economy went into recession because of massive financial deformations. Easy money had led to excessive indebtedness, a housing bubble, and dangerous levels of leverage. The problems were the distortions, not a lack of momentum. The real question is not whether the GDP statistics exhibit the right velocity but whether the underlying dislocations—which, to the chagrin of the econometricians, cannot be easily ascertained from the macro-data—have dissolved.

Feeling Better but Still Sick

The Fed believes it has healed an economy that was sick from easy money with more easy money. The patient is feeling better and can soon be released from intensive care. In my view, the patient is still sick and now suffers from a dangerous addiction to boot. The “feeling-better” bit just may be a lingering drug high from Dr. Bernanke’s generous medication. Withdrawal symptoms may surface soon. If they do, Dr. Bernanke will simply open the medicine cupboard again. Don’t forget, only a few weeks ago the man appeared on TV and tried to talk up the Russell 3000 stock index.

I do not doubt that, if measured by overall GDP, the U.S. economy is currently doing better. I would be foolish to take on the Fed on this point. The Fed has a staff of 200-plus economists, most of them, I assume, from America’s finest universities (which doesn’t mean they are good economists but at any rate probably good statisticians). If they say there are signs of life in the economy, that’s good enough for me.

Where I disagree is on the narrative. The deformations are largely still there. How can they not be, given the enormous policy effort to suppress the very market forces that would, in a free market, have exposed and liquidated these deformations? They are still visible, among other indicators, in high degrees of indebtedness. And they matter.

Untrustworthy Projections

That is why I am mistrustful of the Fed’s projections. Their theories compel them to believe in virtuous cycles and escape velocity and to disregard imbalances and distortions. Any sustained removal of super-easy money will allow these deformations to resurface and immediately cloud the near-term cyclical outlook. According to my worldview, this should be allowed to happen, as it is part of the essential healing process. But it runs counter to the Fed’s worldview and the Fed’s view of its own mission.

The one institution that certainy lacks escape velocity is the Fed. It will remain hostage to the financial monsters it created and the dangerous misconception of its own grandeur.

Detlev Schlichter ([email protected]) is a London-based economist and author of Paper Money Collapse—The Folly of Elastic Money and the Coming Monetary Breakdown (John Wiley & Sons , 2011), which won the getAbstract International Book Award. Used with permission of detlevschlichter.com.