Posted by: Dirk | November 19, 2013

QEx: central banks are still directly changing the distribution

The fact that quantitative easing (QE) leads to a distribution of wealth has been the topic of a recent McKinsey paper, which includes the following graph:


Not all of the change in net interest income is due to QE. Nevertheless, QE does change the prices of financial assets in general as it creates more demand for these. This must mean that prices go up. This policy has prompted Andrew Huszar, who led the QE programme, to say sorry to America publicly in the WSJ:

I can only say: I’m sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed’s first plunge into the bond-buying experiment known as quantitative easing. The central bank continues to spin QE as a tool for helping Main Street. But I’ve come to recognize the program for what it really is: the greatest backdoor Wall Street bailout of all time.


And the impact? Even by the Fed’s sunniest calculations, aggressive QE over five years has generated only a few percentage points of U.S. growth. By contrast, experts outside the Fed, such as Mohammed El Erian at the Pimco investment firm, suggest that the Fed may have created and spent over $4 trillion for a total return of as little as 0.25% of GDP (i.e., a mere $40 billion bump in U.S. economic output). Both of those estimates indicate that QE isn’t really working.

I have discussed QE on this blog before (September 2012):

Here is my reading of the situation. Apparently, some market participants are (still) believing that quantitative easing is expansionary. Hence they speculate on rising prices, thus driving inflation expectations upward. However, there will be a Wile E. Coyote moment when they collectively understand that they have gone over the cliff. When, nobody knows. It probably will have something to do with bad, really bad data from the real economy which shows that demand is falling. Less demand equals less output, and when the demand from the real economy for primary products is not made up by speculative demand financed by debt prices will adjust. All of this will happen in an environment of very low interest rates, which is not stimulating economic activity.

This is more or less a correct analysis, I’d say. The only missing puzzle is the Wile E Coyote moment, but then I also said that nobody knows when it would happen. What we have seen so far is that lower interest rates do not lead to more consumption, as some central bankers argue, and they do also not translate into an investment boom of any kind. By investment I mean investment in investment goods, not financial investments. So, we are still in a crisis that now more than ever looks to be a crisis that will be with us for many years to come. However, there is still disagreement as to why we have this crisis exactly and when it will be over. Paul Krugman sides with Larry Summers pointing at demography and writes:

Think of it this way: during the period 1960-85, when the U.S. economy seemed able to achieve full employment without bubbles, our labor force grew an average 2.1 percent annually. In part this reflected the maturing of the baby boomers, in part the move of women into the labor force.

This growth made sustaining investment fairly easy: the business of providing Americans with new houses, new offices, and so on easily absorbed a fairly high fraction of GDP.

Now look forward. The Census projects that the population aged 18 to 64 will grow at an annual rate of only 0.2 percent between 2015 and 2025. Unless labor force participation not only stops declining but starts rising rapidly again, this means a slower-growth economy, and thanks to the accelerator effect, lower investment demand.

The first thing to do here is to find counterexamples. Is there a country with really, really nice demographics that is also in crisis? Here’s the population pyramid of Ireland:

PyramidirelandThe country is in crisis as well, even though it’s population pyramid looks pretty good. Now that 400,000 people have left the Republic it might look different though. Let’s get back to the question of why we have those bubbles. Krugman writes:

But as Larry emphasizes, there’s a big problem with the claim that monetary policy has been too loose: where’s the inflation? Where has the overheated economy been visible?

So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers’s answer is that we may be an economy that needs bubbles just to achieve something near full employment – that in the absence of bubbles the economy has a negative natural rate of interest. And this hasn’t just been true since the 2008 financial crisis; it has arguably been true, although perhaps with increasing severity, since the 1980s.

The natural explanation, I would have guessed, is inequality. John Cassidy at the New Yorker just published an article which shows the scale of inequality in the US. Here is one of the graphs:


It seems that just like in the Great Depression we’ve reached a moment of very, very high inequality. So, how would that manner in terms of macroeconomics? Well, we know that poor people consumer a lot of their disposable income and rich people less so. “Estimated saving rates range from zero for the bottom quintile of the income distribution to more than 25 percent of income for the top quintile”, is what Dynan et al (2004) find. So, redistributing from poor to rich leads to less demand. This can be compensated by net exporting (Germany, China, Japan), a rise in investment through a bubble (US, Ireland, Spain) or a rise in government spending (not really: Greece).

So, it would boil down to a really simple, Keynesian answer: redistribution of income leads to a demand gap, which can be filled by investment bubbles as long as they run. But one day nobody will want to borrow because of faltering aggregate demand. It’s a demand problem, not a supply problem. This is also what Joseph Stiglitz says:

There are four major reasons inequality is squelching our recovery. The most immediate is that our middle class is too weak to support the consumer spending that has historically driven our economic growth. While the top 1 percent of income earners took home 93 percent of the growth in incomes in 2010, the households in the middle — who are most likely to spend their incomes rather than save them and who are, in a sense, the true job creators — have lower household incomes, adjusted for inflation, than they did in 1996. The growth in the decade before the crisis was unsustainable — it was reliant on the bottom 80 percent consuming about 110 percent of their income.

Second, the hollowing out of the middle class since the 1970s, a phenomenon interrupted only briefly in the 1990s, means that they are unable to invest in their future, by educating themselves and their children and by starting or improving businesses.

So, we have a split now in the Keynesian camp between supply-siders like Paul Krugman and demand-siders like Joseph Stiglitz. Interesting.

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