Saturday, August 2, 2014
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Ten QE Questions

NEW YORK – Most observers regard unconventional monetary policies such as quantitative easing (QE) as necessary to jump-start growth in today’s anemic economies. But questions about the effectiveness and risks of QE have begun to multiply as well. In particular, ten potential costs associated with such policies merit attention.

First, while a purely “Austrian” response (that is, austerity) to bursting asset and credit bubbles may lead to a depression, QE policies that postpone the necessary private- and public-sector deleveraging for too long may create an army of zombies: zombie financial institutions, zombie households and firms, and, in the end, zombie governments. So, somewhere between the Austrian and Keynesian extremes, QE needs to be phased out over time.

Second, repeated QE may become ineffective over time as the channels of transmission to real economic activity become clogged. The bond channel doesn’t work when bond yields are already low; and the credit channel doesn’t work when banks hoard liquidity and velocity collapses. Indeed, those who can borrow (high-grade firms and prime households) don’t want or need to, while those who need to – highly leveraged firms and non-prime households – can’t, owing to the credit crunch.

Moreover, the stock-market channel leading to asset reflation following QE works only in the short run if growth fails to recover. And the reduction in real interest rates via a rise in expected inflation when open-ended QE is implemented risks eventually stoking inflation expectations.

Third, the foreign-exchange channel of QE transmission – the currency weakening implied by monetary easing – is ineffective if several major central banks pursue QE at the same time. When that happens, QE becomes a zero-sum game, because not all currencies can fall, and not all trade balances can improve, simultaneously. The outcome, then, is “QE wars” as proxies for “currency wars.”

Fourth, QE in advanced economies leads to excessive capital flows to emerging markets, which face a difficult policy challenge. Sterilized foreign-exchange intervention keeps domestic interest rates high and feeds the inflows. But unsterilized intervention and/or reducing domestic interest rates creates excessive liquidity that can feed domestic inflation and/or asset and credit bubbles.

At the same time, forgoing intervention and allowing the currency to appreciate erodes external competitiveness, leading to dangerous external deficits. Yet imposing capital controls on inflows is difficult and sometimes leaky. Macroprudential controls on credit growth are useful, but sometimes ineffective in stopping asset bubbles when low interest rates continue to underpin generous liquidity conditions.

Fifth, persistent QE can lead to asset bubbles both where it is implemented and in countries where it spills over. Such bubbles can occur in equity markets, housing markets (Hong Kong, Singapore), commodity markets, bond markets (with talk of a bubble increasing in the United States, Germany, the United Kingdom, and Japan), and credit markets (where spreads in some emerging markets, and on high-yield and high-grade corporate debt, are narrowing excessively).

Although QE may be justified by weak economic and growth fundamentals, keeping rates too low for too long can eventually feed such bubbles. That is what happened in 2000-2006, when the US Federal Reserve aggressively cut the federal funds rate to 1% during the 2001 recession and subsequent weak recovery and then kept rates down, thus fueling credit/housing/subprime bubbles.

Sixth, QE can create moral-hazard problems by weakening governments’ incentive to pursue needed economic reforms. It may also delay needed fiscal austerity if large deficits are monetized, and, by keeping rates too low, prevent the market from imposing discipline.

Seventh, exiting QE is tricky. If exit occurs too slowly and too late, inflation and/or asset/credit bubbles could result. Also, if exit occurs by selling the long-term assets purchased during QE, a sharp increase in interest rates might choke off recovery, resulting in large financial losses for holders of long-term bonds. And, if the exit occurs via a rise in the interest rate on excess reserves (to sterilize the effect of a base-money overhang on credit growth), the ensuing losses for central banks’ balance sheets could be significant.

Eighth, an extended period of negative real interest rates implies a redistribution of income and wealth from creditors and savers toward debtors and borrowers. Of all the forms of adjustment that can lead to deleveraging (growth, savings, orderly debt restructuring, or taxation of wealth), debt monetization (and eventually higher inflation) is the least democratic, and it seriously damages savers and creditors, including pensioners and pension funds.

Ninth, QE and other unconventional monetary policies can have serious unintended consequences. Eventually, excessive inflation may erupt, or credit growth may slow, rather than accelerate, if banks – faced with very low net interest-rate margins – decide that risk relative to reward is insufficient.

Finally, there is a risk of losing sight of any road back to conventional monetary policies. Indeed, some countries are ditching their inflation-targeting regime and moving into uncharted territory, where there may be no anchor for price expectations. The US has moved from QE1 to QE2 and now to QE3, which is potentially unlimited and linked to an unemployment target. Officials are now actively discussing the merit of negative policy rates. And policymakers have moved to a risky credit-easing policy as QE’s effectiveness has waned.

In short, policies are becoming more unconventional, not less, with little clarity about short-term effects, unintended consequences, and long-term impacts. To be sure, QE and other unconventional monetary policies do have important short-term benefits. But if such policies remain in place for too long, their side effects could be severe – and the longer-term costs very high.

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  1. CommentedRobert Lunn

    Can you define "conventional" monetary policy for us? If that definition is "what we had prior to the crisis", defend why that's any good.

  2. CommentedNeeraj Jain

    Mr. Roubini It is true that QE is not a complete solution, but austerity can not help an economy to recover from the recession. People in any country only care about two things :
    first is "inflation" and second is "unemployment", and QE is best way to attack on the both the issue.
    Most of the point raised by you is completely flawed, prejudice and oxymoronically described.
    Mr. Roubini have to accept that financial market and real market have no correlation at all and India is shining example where stock market burgeoning and growth is falling from last two years.
    QE effect on bond and equity market need to be overlook during the QE process and require to put more focus on the real economy.
    QE as a Zero Sum game assumption is also not valid. Why emerging nation will pursue QE when they are passing through both high growth and inflation rate.
    One more point if the money move from the develop nation to emerging nation, then it will help the emerging nation to meet their infrastructure project, sustain their growth rate in a long run.

    I think Mr. Roubini must learn a lesson from the Japan where just after the implementation of QE, Japan economy show a sign of green shot.

  3. CommentedMichael Lochis

    It isn't true. This is graphic of federal funds rate in USA,r:1,s:0,i:83&iact=rc&dur=182&sig=111830829360781494890&page=1&tbnh=177&tbnw=284&start=0&ndsp=12&tx=209&ty=122

  4. CommentedPaul A. Myers

    Johnny (MoneyWonk)

    I believe you are correct. Holding the assets to maturity will most likely be the path taken since it is probably the path of least political resistance. I believe that in the coming years, policy like water, will run downhill. Tis a feckless age.

    If inflation expectations truly increase and investors start dumping bonds, I would expect the Fed to keep buying assets to dampen the market-imposed money tightening.

    Where all this goes does lack "clarity."

      CommentedRobert Lunn

      Are you assuming we have higher rates with more economic velocity?

  5. Commentedadmir ramadani

    QE policies by lowering interest rates accelerate refinancing and help lower debt levels rather than postpone delivering.

  6. CommentedJoshua Ioji Konov

    Dear Mr.Roubini, from the all 10 points maybe two or three have been justified under the conditions of rapid Globalization, rising Productivities, of China's Industrialization and improving technologies that create conditions for global overproduction, whereas QE was the only way to keep the large economy functioning..., however you are correct about the lack of transmissibility that will cloak the system, the possible bubbles that could bring new recessions, the exit of capital to other markets that could bring stress to these markets. However, if the markets (i.d. economies) do not improve for the pointed issues fixing then the system of economics would not work anyway. The QE was the only way to prevent the US, and now the Japanese economies from chronical deflation and upheaval in a short term, whereas changes and enhancements that have nothing to do with austerity measures are implemented, changes that will improve transmissionability and fair markets competition, but it is not about the "harmful" lower interest rate or the QE....

  7. CommentedJohnny (MoneyWonk)

    Dr. Doom, everybody warns of entering a currency war, but the evidence doesn't show them to be so bad. As B. Eichengreen's study on the Great Depression showed, the countries who left the Gold Standard early and pursued stimulative monetary policy returned to prosperity the fastest. This is because stimulative monetary policy isn't just to boost exports, but the jump start aggregate demand!

    As Matt Yglesias says, a currency war isn't a war at all; it's a party!

  8. Portrait of Pingfan Hong

    CommentedPingfan Hong

    Like any other macroeconomic policies, the QEs are definitely involved trade offs between the salutary and adverse effects. For each negative effect the QES "may" lead to as you listed here, there must be a positive effect you can identify. The key is that the Fed believes the overall positive effects are outweigh the negative ones.

  9. CommentedProcyon Mukherjee

    There can be no better explanation than the one given by Friedman in his seminal paper, 'The Role of Monetary Policy', which came out in the American Economic Review in 1968. It would be worthwhile to note that Friedman's observation "What Monetary Policy Cannot Do- From the infinite world of negation, I have selected two limitations of monetary policy to discuss: (1) It cannot peg interest rates for more than very limited periods; (2) It cannot peg the rate of unemployment for more than very limited periods", shows the difference of the current policy objectives of central banks with what he believed monetary policy had limits to achieve. I reproduce below his explanation:
    "Let the Fed set out to keep interest rates down. How will it try to do so? By buying securities. This raises their prices and lowers their yields. In the process, it also increases the quantity of reserves available to banks, hence the amount of bank credit, and, ultimately the total quantity of money. That is why central bankers in particular, and the financial community more broadly, generally believe that an increase in the quantity of money tends to lower interest rates. Academic economists accept the same conclusion, but for different reasons. They see, in their mind's eye, a negatively sloping liquidity preference schedule. How can people
    be induced to hold a larger quantity of money? Only by bidding down interest rates. Both are right, up to a point. The initial impact of increasing the quantity of money at a faster rate than it has been increasing is to make interest rates lower for a time than they would otherwise have
    been. But this is only the beginning of the process not the end. The more rapid rate of monetary growth will stimulate spending, both through the impact on investment of lower market interest rates and
    through the impact on other spending and thereby relative prices of higher cash balances than are desired. But one man's spending is another man's income. Rising income will raise the liquidity preference schedule and the demand for loans; it may also raise prices, which
    would reduce the real quantity of money. These three effects will reverse the initial downward pressure on interest rates fairly promptly, say, in something less than a year. Together they will tend, after a somewhat longer interval, say, a year or two, to return interest rates to the level they would otherwise have had. Indeed, given the tendency for the economy to overreact, they are highly likely to raise interest rates temporarily beyond that level, setting in motion a cyclical adjustment process."

    There is one more potent reason that the credit boom driven by Fed QE can run up to a point as the collateral 'transformation' process hits a wall as explained by Jeremy Stein in his speech recently.

  10. CommentedJohnny (MoneyWonk)

    Dr. Doom, I believe you are too pessimistic on a Fed exit. Bernanke has said that they have the tools to unwind the Fed balance sheet, which includes a policy as easy as holding the assets to maturity.

    And even if the Fed had to raise interest paid on excess reserves in order to sop up the extra liquidity or even raise interest rates altogether, well, these losses don't matter anyway. They would in no way impact the U.S. debt or deficit, but just offset future profits. And the only reason interest rates would rise is if the economy is booming again, which would mean that QE worked and that the benefits outweighed the costs.

      CommentedJohnny (MoneyWonk)

      reply to Paul Matthews:

      Bernanke certainly knows what he is doing. He is buying bonds in order to boost AD and stave off deflation, which have nothing to do with central planning. He may be more vocal than his predecessors about calling out Congress, but his claims are warranted given the gridlock in both the houses. As for his policies, they mirror the aggressive monetary action put forth in research by Milton Friedman, Barry Eichengreen, and his own, and are the primary the reason why the U.S. is in the best shape out of all the OECD countries.

      CommentedPaul Mathew Mathew

      Does anyone think Bernanke has the slightest clue about what he is doing?

      He is at best making it up as he goes along - at worst a complete fool in that he thinks he has the ability to centrally plan an economy.

      Ask Soviet Russia about that experiment.

      There is no way that stuffing trillions of dollars into the global economy and keeping interest rates at zero is not going to have massive deadly repercussions.

      Last but not least - would you have faith in a man who was so woefully wrong in the lead up to this catastrophe

  11. CommentedPavlos Papageorgiou

    On point 8, QE as redistribution from creditors to debtors, the objections seem surprising. As you know, both austerity and taxation to pay back bailout liabilities are extremely controversial. Achieving some of this through QE appears easier and relatively painless by comparison.

    Also, what's your view on money creaton by banks of the kind that fuelled the bubble up to 2007? Given the long list of objections to QE as a policy tool, shouldn't we take a good look at M1 creation since it is in fact the lion's share? If we need strict limits on QE, maybe we also need to take a good look at narrow banking and similar proposals.

  12. CommentedPatrick Lietz

    Many of the points addressed in this contribution are valid, particularly with regard to the onset of currency wars.

    However, a reduction in QE would almost certainly lead to a further erosion of the banks' balance sheets, impacting the stock markets adversely and reduce lending. It would also raise the specter of further bank failures and have unknown effects on the enormous derivatives market. A second bank bailout is politically and financially not feasible.

    The USD (still) is the reserve currency and an end of QE would have global knock on reverberations, the impact of which would be difficult to oversee. The FED and other CB's implementing QE policies are caught between a rock and a hard place.

    Nevertheless, an inflationary policy is, in my view, preferable to a deflationary policy because it offers more employment opportunities for the population. And, given the historic heights of wealth inequality, a redistribution would need to occur anyway as history repeatedly has shown.

    The long-term costs will have to be paid either way.