Quantitative Easing – A Case Study in the Limitations of Monetary Policy

water and energy state as analogous to easy monetary policy

Water and Money Flow to the Lowest Energy State

As you might guess, add me to the list of hind-sighters looking back and calling Quantitative Easing a failed policy. The idea and intentions were good, but any objective observer can only conclude that this has been a perfect case study of enthalpy. In physics – and apparently in finance, all bodies seek the lowest energy state.

To wit: The Federal Reserve Bank has bought or is buying every last long-term bond and MBS (mortgage backed security) it can get its hands on – presently at a rate of $85 billion per month (or $1 Trillion per year). The intended (good) result from this was the downward pressure on long-term (specifically housing / mortgage) interest rates. This was expected to also have an additional economic benefit of driving down corporate borrowing costs (which it has).

The Lowest Energy State Monetary Policy of Lowering Yields

The ability of the Federal Reserve to gain hold of wide sections of the yield curve has been very successful. The Fed lowered rates (on the short end) to zero, and by being the ultimate force (and source) of demand on the long end, pushed 10Y and mortgage rates to record low levels. I am sure the Fed Board of Governors pat themselves on the back and congratulate out-going Chairman Bernanke for a job well done in that regard. The problem with all the congratulations is that the results of the effective policy manuevers have been a far cry different than what was intended. The Fed has created a tremendous supply of cheap money (a principal objective); the only problem is that those funds were used (almost entirely) in the least productive manner possible. Regardless of how people feel about who had access to the money (either directly via the Fed or via access to credit markets), almost the entire amount has ended up in a few excess reserve accounts rather than in the hands of the public. The entire Quantitative Easing program resulted in virtually no productive (capital investment) credit growth, and virtually no job growth.

Basically from a physics perspective the money started out at a very low energy state and then directly cascaded to the lowest energy state and stayed there – releasing the tiniest amount of economic boost possible then remained in a coma – with an occasional (low yield) heartbeat.

The Limitations of Monetary Policy

The above result describes the principal difficulty in using monetary policy to boost growth. When in a relatively normal economy, occasional rate changes up or down have the effect of juicing or starving the economic activity via credit creation (the non-productive segment of the economy). The problem arises when economic activity falls outside the “normal” range of growth / modest declines and the real productive part of the economy begins to shutdown. When a globally-connected economy enters this state (as it did during and since the financial crisis in 2008) – no amount of monetary policy change in the non-productive segment of the economy is going to restore growth to the productive part. Monetary policy produces low-energy state money which has extremely little impact outside the financial sector. It can add a few dollars to EPS of financial stocks but it will have no impact on economic or jobs growth – monetary policy just doesn’t ever reach the productive part of the economy. We have seen that in the world’s largest ever case study (running since 2008).

Where does the money go then? It’s fairly obvious who the biggest beneficiaries of loose monetary policy have been – the investment banks. No, this is not a post calling for a lynching of the finance sector – as far as I am concerned they have done exactly what anyone would have expected them to do: they took the money given to them and did what investment banks do with that kind of money: they invest it in existing securities and (to a vastly lesser extent) other assets. They did it so well in fact that on numerous occasions household names like JPMorgan and Goldman Sachs went entire quarters without a net trading-day loss.

What About the Impact of Lower Corporate Borrowing Costs?

Critics might argue that the lowering of interest rates on corporate debt would spur additional credit growth in the broader business sector and create an environment for business expansion. The problem is that business expansion requires a great deal more than free (or cheap) credit. Business expansion requires some level of confidence that there is a good opportunity *somewhere* to exploit. Business investment / expansion requires case studies of available opportunities that are expected to generate a positive (and significant) return. Ideally a business with significant amounts of available capital or credit will have a number of positive-return (positive NPV or net-present-value in corporate finance parlance) projects to select from and will then distribute that capital accordingly.

My question is: Where exactly are those positive NPV projects today? One of the biggest challenges to financial modeling is uncertainty of outcomes. The greater level of uncertainty of results, the higher the required return on investment (and hence lower chance of expected positive NPV). Businesses of all sizes today face tidal waves of uncertainty coming from every imaginable direction. To their credit, the Federal Reserve has done about as much as one can expect in reducing uncertainty in financial / credit markets – but who can reduce fear or failure everywhere else? What kind of fears do businesses face? Howabout uncertainty about the new healthcare law? What about data and systems security? Whatabout energy costs? Whatabout the impact of declining demand from demographic shifts? Whatabout the fear of global demand decline? What about the biggest one of all: Frozen Global Governments?

Some or all of these factors (and more) contribute to the decision-making process of capital allocators within corporations and businesses. Corporate finance executives are not dummies and to date have generally availed themselves of the massive amounts of low-cost credit available to them. The only problem is that despite all the available low-cost credit there just aren’t projects anyone can have confidence in. So finance executives do the only sensible thing they can with cheap debt: they buyback (higher cost credit) shares of company stock.

Fiscal Policy and Good Governance Is the Only Way Out

If we have learned anything from the last several years of cheap-credit from Quantitative Easing it is this: Monetary policy has no impact outside a certain range of economic conditions – and no matter how much cheap money you shove down Wall Street’s throat it isn’t going to create jobs on main street. In fact, it is more likely killing jobs and businesses – starved of new and future revenues because larger businesses have no expansion plans and have no choice but to cut costs (and heads) in order to maintain the illusions of EPS growth.

The only way out of this coming economic calamity is good Governance (no deadlock) and (productive) expansionary fiscal policy on a global scale. Without these two things on a global scale, we.are.done.

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Republican House Shuts Down Faith in the System

I really had a hard time believing the Congress could be so stupid as to shut down the government again, yet here we are. Led by none other than the do-nothing leader of the House himself, Speaker John Boehner. The ongoing embarrassment that has become the leadership of the Republican party has continued its path of doing nothing rather than making an honest effort at running the country and doing the People’s business.

Still Trying to Kill Obamacare

One wonders how many elections the Republicans have to lose in a row in order to finally get on with life and try to make things work rather than doing everything they can to prevent government from functioning. Today rather than putting together a spending plan to run the government they are standing with their arms crossed with scowls on their faces blaming anyone but themselves for the embarrassing disfunction of the federal government. This is yet another effort to sabotage the one major piece of legislation of the Obama administration – the Affordable Care Act. On multiple occasions the public has had their say about Obama’s administration (now twice elected) and his health care program specifically.

Republican Led States Still Trying to Sabotage Obamacare as Well

It is no surprise that the vast majority of states enrolling in the Federally managed insurance exchanges are Republican-led. Rather than commit state resources (a.k.a. hire some people to do some work) and make an honest effort at implementing the broad healthcare initiative, Republican-led states have done everything in their power to sabotage, delay, and misinform the public’s new health program. This is a dreadful political mistake on their part, and damaging to the status of the Republican party – once known to be effective managers and financial stewards – now known only as the “take my ball and go home” party.

It may turn out that the Affordable Care Act is not a good program, but no independent thinker (read: voter) is going to blame President Obama and the Democrats who crafted the program now. When legislation is passed and programs are supposed to be built for the public good, the voting populace has a right to expect their elected officials to give it an honest effort. If the programs fail after an honest effort – no one can be said to have “not tried to make it work,” – and then blame is apportioned accordingly (to the law’s authors and supporters).

It Is Just Bad Politics by Republicans

The Republican party lost its identity leading up to the last election, and here the party is again, a year later and absolutely no wiser at the top. The way to prove an adversary wrong (once they’ve implemented law) is to expend the resources to try to make things work, then point out the weaknesses (“it’s too expensive,” “costs went up,” “people got poor quality care,” etc.). Because the party has expended billions of taxpayer dollars fighting the program (rather than trying to make it work) the Republicans will ultimately (presuming Obamacare fails) become the scapegoats.

The only way the Republican party can move forward and re-earn its reputation as leaders, managers, and good stewards is to show John Boehner and Eric Cantor where the exit is. Until those two are gone, there is no hope for long-term success of the party.

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The Financial Markets Are Crazy

Readers will note I have been hunkered down in my bunker – but that hasn’t kept me from keeping up to date with financial markets. As you will no doubt agree – they simply have gone crazy. The grand concept of Quantitative Easing has been taken to the absurd extreme in Japan – not wanting to be outdone by their equally hapless counterparts in New York. And Europe. The result has been – in my opinion – the acceleration of the coming global financial collapse. The end days leading to crisis are marked by crazy volatility – and that volatility is here.

There Is No Recovery in Housing in the US

I first want to dispel one of the current myths in the US housing market. Yes, average housing sale prices are going up – and have come off lows. But what we don’t see is the quality (or lack thereof) inherent of the homes changing hands. The housing market is full of over-priced, poor-quality homes at the median price level – and over-priced outright tear-downs at the bottom end. Houses are changing hands, true – but my money tells me the good ones have gone, and what’s left isn’t worth buying. My instinct tells me the market is going to fall out of housing again – sooner rather than later. A blip up in interest rates and it’s all over again. We may not even have to wait that long.

European Youth Unemployment a Destabilizing Force

Friends at zerohedge.com have been reporting on the 60+% youth unemployment rates in several towns in Spain and at least one in Greece – with generally high rates all over. Even passive Sweden youth riots have already happened this spring – and their unemployment rate was only in the low 20s. It is NOT going to be a fun summer in Greece or Spain. Count on it. Did I mention markets don’t like riots, uncertainty, and volatility?

Looking for a Spark – Where is Marie Antoinette When You Need Her

Seriously – all we need is a catalyzing spark. Some really good ammo was fired this week in the testimony by Apple CEO Tim Cook – but the message was lost on the sleepy Americans (not) listening to it. Apple has billions in earnings stashed in US banks on US soil on which they have paid (essentially) zero taxes (total – let alone US)? Any world citizen who didn’t think that global finances weren’t rigged against them before should have figured it out this week (thanks Testosterone Pit). Oddly enough that damning revelation didn’t catch on anywhere. The story was largely buried. So what event or misstep will be the spark that brings the meltdown? Will it be China’s efforts to thwart the copper carry-trade financing schemes that are inflating the yuan? Will Japanese savers finally say “Enough!” and put an early end to Abenomics and Quantitative Easing there? Will someone at the Fed finally screw up and admit that US Quantitative Easing has resulted in a WIDENING, rather than a NARROWING of income inequality in the US?

In the end that is what it is all about anyway. That’s what the last decade has been about: income and economic inequality. The cabal has pushed the debt-slaves to the very edge of the cliff and they are falling off in droves. One wonders which country’s youth will be first to fight back. One thing is certain: it’s going to be a very hot summer in Spain, Italy, and Greece.

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