The Bear’s Lair: Congress needs to outlaw QE

Goldman Sachs is now calling for the U.S. Federal Reserve to instigate a new round of “quantitative easing” bond purchases. Jeremy Corbyn, the newly elected nut-left leader of a Labour party that has always deep down been nut-left itself, wants the Bank of England to print money for state-directed boondoggles.  The gigantic Japanese quantitative easing program continues at full blast even as Japanese politicians call for yet more deficit spending. In short, the worst sort of venal politicians and crony capitalists think they have discovered a source of free money. They need to be stopped.

Massive use of quantitative easing has always been decried by responsible economists. When I was an advisor with the U.S. Treasury Department in the 1990s it was almost the first principle that Treasury instilled into its emerging East European clients. My Treasury colleagues, almost all center-left in U.S. politics, saw central banks lending to governments as one of the premier temptations leading emerging markets down the road to perdition. Clients were told that it was dishonest finance, which would almost certainly lead to hyperinflation if followed. The chains of the 1919-23 Weimar Republic’s central-bank-led hyperinflation were rattled vigorously to clients to emphasize this point.

Most of those Treasury officials are now retired, which is a good thing for they would otherwise look pretty silly right now. Quantitative easing, by which central banks lend money directly to governments, has been in use all over the world in the last half decade. It has very obviously produced no inflation at all, and the initial warnings of dire consequences for budgetary discipline have completely died away. Now Corbyn can suggest that the Bank of England print money to finance his crazy spending schemes and his proposal is derided only because it comes from a known left-wing eccentric who happens to have become leader of one of the U.K’s two major parties. In reality it bears a strong resemblance to the current or recent policies of pretty well all major rich-country governments.

The failure of inflation to take off is really infuriating, as well as being inexplicable. If inflation had soared, we could take all the copybook headings of the 1990s Treasury officials and explain gently to Janet Yellen and the other central bank chiefs just why their policy has been a disaster. As it is, inflation’s failure to soar has called into question the entire body of conventional monetary theory, allowing the inflationists and free-money types to roam unchecked about the policy landscape.

The result is that QE is unstoppable until it has produced an economic disaster and the longer it is continued, the more long-term damage it will do. Ben Bernanke’s ending of QE in 2013-14 was generally agreed to by the consensus of economists (although it was done agonizingly slowly), and brought at least a little more discipline back to financial markets. Politically, there is now every danger that the motor of monetary chaos will be revved up again, in the United States as well as in Europe and Japan, with who knows what consequences.

Needless to say, inflation is not the only danger from quantitative easing. Contrary to the Corbyn view, there are no free lunches; funding government spending through the central bank does not magically make it affordable. Money created by the central bank out of thin air still represents a valid claim on resources, which have to be found from somewhere. Using central bank money to fund unproductive activities at the very least diverts resources of labor and materials from productive ones.

Central banks are not capable of directing investment dollars optimally; indeed it is not their function to do so. Thus creation of money and its allocation by the central bank will result in a massive misallocation of resources, which will be deployed sub-optimally into the economy. The result will be a massive deficit in productivity growth – just as we have seen in the United States since 2011, when the slack from the recession had been used up (though it seems likely that part of the current productivity deficit results from a blast of over-regulation by the Obama administration.) A sensible central bank might well have done QE purchases in 2009-10 when the financial system was wrecked by the 2008 crisis, but it would surely have stopped them by 2011, when it was obvious that the U.S. economy was in a process of recovery.

The real damage done by central bank purchases of government bonds is that they remove the incentives for governments to balance their budgets. Japanese public debt is around 240% of GDP and there is a desperate need to stop it rising any further and begin to bring it down, yet Japanese politicians are deterred from doing so because when the Bank of Japan purchases vast quantities of JGB government bonds, it automatically solves the government’s financing problem – and, they think, the default problem.

However the real difficulty is that this can’t go on forever. The Fed’s balance sheet is now over $4.5 trillion and the Bank of Japan’s balance sheet is proportionately even larger. At some point, both institutions have to stop growing their balance sheets before they swallow their entire respective economies. They will then be subject to massive interest rate risk (and indeed credit risk, at least in Japan’s case.)

At this stage, the most likely outcome from Japanese policies, which have been appallingly bad for the last 20 years except for a brief shining interlude under Junichiro Koizumi (2001-06) is a massive default. This will now affect international markets, because foreign investors have been buying JGBs in increasing quantities. However its most devastating effect will be on the Japanese middle aged and older, who will find their savings have been wiped out, as JGBs are written down to a fraction of their value, causing institutions such as the Post Bank to default. As a collateral effect, the ability of Western governments to run perpetual deficits will be eliminated, because markets will see them as proceeding down the Japanese road. That, of course, will be a thoroughly good thing.

Given the damage done by QE, there should be some penalty for advocating it. The sillier politicians like Corbyn perhaps cannot be expected to know better, but Goldman Sachs undoubtedly does. Yet that house advocates QE because it stands to benefit financially to a massive extent from the excess asset creation and overvaluation produced by it.

There really should be some form of “slut-shaming” whereby companies are discouraged from advocating policies they know to be damaging to the economy, simply because they stand to benefit from them financially. Respectable banks advocating the perpetuation of Fannie Mae and Freddie Mac would come into this category, as would agribusiness companies advocating the making of ethanol from corn starch and the perpetuation of sugar, cotton and other agricultural quotas that impoverish Mali and Haiti while rendering domestic U.S. products far more expensive than they need to be. Goldman Sachs, along with the other major banks, would find itself “shamed” by such a mechanism on all too many occasions.

Zero interest rates are a foolish policy, and cause all kinds of economic inefficiencies and distortions. But “quantitative easing” bond purchases carry this foolishness to a new level, empowering the worst kinds of politicians, allowing governments to pour money down rat-holes in infrastructure and housing and raising the likelihood of a gigantic default/crash that in the worst case could carry the world’s economy back several centuries.

A burst of inflation would stop this nonsense, because it would make the costs of these policies all too apparent to the public at large. It may seem eccentric to long for a resurgence of inflation but frankly, nothing at present is more necessary.


(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)