Thursday, November 27, 2014

Occupy QE

NEW HAVEN – The Federal Reserve continues to cling to a destabilizing and ineffective strategy. By maintaining its policy of quantitative easing (QE) – which entails monthly purchases of long-term assets worth $85 billion – the Fed is courting an increasingly treacherous endgame at home and abroad.

By now, the global repercussions are clear, falling most acutely on developing economies with large current-account deficits – namely, India, Indonesia, Brazil, Turkey, and South Africa. These countries benefited the most from QE-induced capital inflows, and they were the first to come under pressure when it looked like the spigot was about to be turned off. When the Fed flinched at its mid-September policy meeting, they enjoyed a sigh-of-relief rally in their currencies and equity markets.

But there is an even more insidious problem brewing on the home front. With its benchmark lending rate at the zero-bound, the Fed has embraced a fundamentally different approach in attempting to guide the US economy. It has shifted its focus from the price of credit to influencing the credit cycle’s quantity dimension through the liquidity injections that quantitative easing requires. In doing so, the Fed is relying on the “wealth effect” – brought about largely by increasing equity and home prices – as its principal transmission mechanism for stabilization policy.

There are serious problems with this approach. First, wealth effects are statistically small; most studies show that only about 3-5 cents of every dollar of asset appreciation eventually feeds through to higher personal consumption. As a result, outsize gains in asset markets – and the related risks of new bubbles – are needed to make a meaningful difference for the real economy.

Second, wealth effects are maximized when debt service is minimized – that is, when interest expenses do not swallow the capital gains of asset appreciation. That provides the rationale for the Fed’s zero-interest-rate policy – but at the obvious cost of discriminating against savers, who lose any semblance of interest income.

Third, and most important, wealth effects are for the wealthy. The Fed should know that better than anyone. After all, it conducts a comprehensive triennial Survey of Consumer Finances (SCF), which provides a detailed assessment of the role that wealth and balance sheets play in shaping the behavior of a broad cross-section of American consumers.

In 2010, the last year for which SCF data are available, the top 10% of the US income distribution had median holdings of some $267,500 in their equity portfolios, nearly 16 times the median holdings of $17,000 for the other 90%. Fully 90.6% of US families in the highest decile of the income distribution owned stocks – double the 45% ownership share of the other 90%.

Moreover, the 2010 SCF shows that the highest decile’s median holdings of all financial assets totaled $550,800, or 20 times the holdings of the other 90%. At the same time, the top 10% also owned nonfinancial assets (including primary residences) with a median value of $756,400 – nearly six times the value held by the other 90%.

All of this means that the wealthiest 10% of the US income distribution benefit the most from the Fed’s liquidity injections into risky asset markets. And yet, despite the significant increases in asset values traceable to QE over the past several years – residential property as well as financial assets – there has been little to show for it in terms of a wealth-generated recovery in the US economy.

The problem continues to be the crisis-battered American consumer. In the 22 quarters since early 2008, real personal-consumption expenditure, which accounts for about 70% of US GDP, has grown at an average annual rate of just 1.1%, easily the weakest period of consumer demand in the post-World War II era. That is the main reason why the post-2008 recovery in GDP and employment has been the most anemic on record.

Trapped in the aftermath of a wrenching balance-sheet recession, US families remain fixated on deleveraging – paying down debt and rebuilding their income-based saving balances. Progress has been slow and limited on both counts.

Notwithstanding sharp reductions in debt service traceable to the Fed’s zero-interest rate subsidy, the stock of debt is still about 116% of disposable personal income, well above the 43% average in the final three decades of the twentieth century. Similarly, the personal saving rate, at 4.25% in the first half of 2013, is less than half the 9.3% norm over the 1970-1999 period.

This underscores yet another of QE’s inherent contradictions: its transmission effects are narrow, while the problems it is supposed to address are broad. Wealth effects that benefit a small but extremely affluent slice of the US population have done little to provide meaningful relief for most American families, who remain squeezed by lingering balance-sheet problems, weak labor markets, and anemic income growth.

Nor is there any reason to believe that the benefits at the top will trickle down. With real consumption stuck on a 1% growth trajectory, the bulk of the US population understandably views economic recovery and job security very differently from those enamored of wealth effects. The Fed’s goal of pushing the unemployment rate down to 6.5% is a noble one. But relying on wealth effects targeted at the rich to achieve that goal remains one of the great disconnects in the art and practice of economic policy.

The Occupy Wall Street movement began two years ago this month. While it can be criticized for its failure to develop a specific agenda for action, it galvanized attention to income and wealth inequality in the US and around the world. Unfortunately, the problem has only worsened.

Lost in the angst over inequality is the critical role that central banks have played in exacerbating the problem. Yes, asset markets were initially ecstatic over the Fed’s decision this month not to scale back QE. The thrill, however, was lost on Main Street.

That is precisely the point. The Fed’s own survey data, which underscore the concentration of wealth at the upper end of the US income distribution, fit the script of the Occupy movement to a tee. QE benefits the few who need it the least. That is not exactly a recipe for a broad-based and socially optimal economic recovery.

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    1. CommentedProcyon Mukherjee

      Spending from capital gains, notional included, can hardly be a long term fuel for growth; on the other hand taxing this spend does not help and is non-existent as a policy, so where does it leave the fiscal side?

    2. CommentedWayne Davidson

      The unprecedented bailout of a government sanctioned corrupted banking system and a bias toward government spending was never envisioned as a Keynesian principle. If consumer confidence and by default consumer spending is a cornerstone of GDP growth, why are the main beneficiaries of the governments flawed QE policy, the wealthiest 10% of the population. Resumption of the status quo is not coherent fiscal policy.

    3. CommentedJan Smith

      Excellent column, as far as it goes.

      But does it go far enough? QE is conventionally understood as inconsistent with declining fiscal deficits. Monetary expansion vs. fiscal contraction, blah, blah blah. But this assumes a closed economy.

      However, because the American economy is wide open, QE and declining fiscal deficits should be understood as complementary means to the same end, which is to repair the nation's balance sheet. (By the way, under many conditions, as the Asians would tell us, low interest rates do not reduce but actually augment the household savings.)

      So the US is like the EU, hellbent on thrift.

      And who will assume the US's former role, "the consumer of the last resort?" If American consumption was not large enough to sustain world growth, neither is China, nor Japan, indeed, not even China + Japan.

      What's the way out of this Hobbesian warre of thrifty sovereigns? Only pipedreams, perhaps: an International Clearing Union or, if that is insufficient, a world sovereign government. Then closed-economy macroeconomics would apply and monetary and fiscal policy might actually work.

    4. CommentedTomas Kurian

      Well, Fed is not designed to do a fiscal policy.

      All it can do is to keep throwing a lot of money onto a barn with hope that some of it will get inside through keyhole.

    5. CommentedStepan February

      For GDP to grow in real terms, at some point, all this "wealth" needs to find its way into capital and labor. There does not seem to be enough real growth opportunities for all this money, so it stagnates or pours into unproductive uses like housing or more consumption.

      The current growth constraints, like climate concerns and weak infrastructure, education and basic research, can only be addressed by state or global action. Unfortunately, governments all over the world are not ready to address these, because there are no clear solution roadmaps.

      Some of these problems, like climate change, are not even defined well enough to begin to solve. So everyone is patiently keeping their powder dry, while the interdisciplinary stagnation and confusion resolves itself into some self-organized flow.

    6. CommentedCraig Hardt

      I think it's been well-documented that the Fed recognizes its limitations in reducing inequality/unemployment. It regularly advocates for more fiscal-side policies to address our slow growth and anemic jobs recovery.

      QE may be inefficient, but it still helps those who need help most on the margin, even if it has bigger benefits for the wealthy.

    7. CommentedStamatis Kavvadias

      Some logical claims, some strange number-argument associations. Popular conclusion. Hmm... Who knows what is on his mind really?

      Maybe he wants to warn that QE will either stay in risky markets, or create inflation and bubble at home. Not really convincing that inequality is his concern.

    8. CommentedShane N

      It should be clear by now that it doesn't matter who's in power, the levers are being controlled by the rich. Robert Reich's new movie opening this weekend, Inequality for All, could be an opportunity to start talking about inequality and the negative effects it has on all sections of society, including the rich -

    9. CommentedStephen Hay

      Stephen you are on the money. I suspect Ed Milliband must share your views read this so he and the UK Lib Dems now propose to tax the rich on their assets by the introduction of a mansion tax on all houses over £2,000,000. The Central Bank is 1/2 of the double act and inflates asset values which the Treasury then taxes. I am not an economist and haven't done the numbers so don't know how much they expect to generate but it is a rather cumbersome, insidious and dishonest way to go about things