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A Half Cheer for Quantitative Easing

By Ed Moy,

In her first testimony as the chair of the Federal Reserve, Janet Yellen told Congress that she’ll continue the gradual tapering of its quantitative easing (QE) program unless something bad happens to the economy. With the beginning of the end of QE assured, anyone evaluating the success of the program would, at best, conclude that the results are mixed.

QE has helped make progress toward the Fed’s target unemployment rate of 6.5 percent, but the goal for an inflation rate of 2 percent is incomplete, and the program has caused many serious negative unintended consequences.

Here is a quick primer on QE. QE is shorthand for a series of controversial programs by the Fed intended to stimulate our economy out of its deep recession. Its main theory is to make lots of money available to financial institutions so they can loan to people and businesses at very cheap interest rates. This, in turn, leads to more spending on cars and appliances among individuals and the expansion, inventories and new employees by businesses. All this should result in more jobs (lowering the unemployment rate to 6.5 percent) and more economic growth (increasing inflation to 2 percent).

The Fed does this by creating money out of thin air and using it to buy assets from financial institutions like their investments in government bonds and mortgage-backed securities. With their coffers overflowing with unused money, the profit-hungry financial institutions would make money by loaning this money to people and businesses. The Fed would then sell back these assets to the financial institutions when the economy improves and cancel out all the money created to buy the assets in the first place and therefore avoid runaway inflation. Everybody happy.

So how has the program worked?

Unemployment has declined from 10 percent at the peak of the recession in 2010 to 6.6 percent last month. But many of the jobs created were low-paying jobs in the service sector, like the restaurant and hospitality industry, and not the high-paying manufacturing, mining and construction jobs that the Fed was hoping for. To add insult to injury, the number of people giving up and no longer looking for jobs exploded to a historic record, artificially bringing the unemployment rate down. That is why Yellen said that there is much more work to do to restore the labor market and the unemployment number should not be the only metric. This deserves a half cheer at best.

The inflation rate has fluctuated from 0.1 percent to 3.9 percent since the first of three rounds of QE started in November 2008, and today it stands at 1.5 percent. This indicates that the economy’s recovery is very modest and fragile. To get to 2 percent inflation, the economy needs steady growth between 3 percent and 4 percent. Lower growth risks deflation and then super inflation, and higher growth risks high inflation. Most economic indicators have been mixed, but steadily improved until the end of 2013 and early 2014, when some previously improving indicators, like consumer spending and manufacturing activity, were declining. With the slow recovery losing some steam, this deserves no cheer yet.

However, to accomplish its two stated goals of employment and inflation, the Fed’s QE programs have many serious and negative unintended consequences.

First, the financial institutions have invested QE funds into the stock market and emerging markets instead of loaning money to people and businesses. This has created a stock market bubble and helped other countries grow instead of the United States.

Loans require accepting risk and lots of administrative costs and headaches, so skittish banks made it tough for almost all to qualify for a loan. A sluggish economy also dramatically decreased the demand for loans by businesses that did not see expansion opportunities. Instead, businesses used some loans to buy back shares or refinance high-interest loans, neither of which create jobs or economic growth, but rather benefit share prices and balance sheets. Reports of increased corporate earnings have come mainly from cost cutting and improved productivity (which also are not good for jobs or economic growth) instead of growing revenues from expanding the business.

Seeking higher returns and short-term gains, financial institutions poured money into the stock market and invested in businesses in emerging markets that had robust growth. With QE funds not doing what they were supposed to do, the Fed had little choice but to end the program gently. That is why the stock market and the currencies of emerging markets tanked when the Fed started tapering its asset purchases. Without propping up by the Fed, investors are starting to focus on the fundamentals, which are mixed and do not support many high stock prices.

Second, no country in the world has ever unwound a $4.4 trillion (and counting) stimulus program before. The exit strategy of the Fed selling back the government bonds and mortgage-backed securities to financial institutions is an untested theory. That theory is predicated on the assumption that financial institutions will do the right thing AND be willing to give up gobs of cheap money earning tons of profits to buy low-earning government bonds and risky mortgage-backed securities. That kind of bet makes me pretty queasy.

Third, if financial institutions do not buy back these assets, the Fed will not have enough money coming in to cancel all the money it printed to buy the assets in the first place. The Fed could just allow the excess money to exist, which would mean a big jump in inflation (more dollars chasing the same goods making everything more expensive and the dollar’s value shrink). Or the Fed could sell those assets to non-U.S. investors like China. That would result in the largest transfer of wealth in history from American individuals to Wall Street fat cats paid with money borrowed from China and paid back by taxpayers.

Fourth, QE has enabled dysfunctional behavior by our elected officials that will be hard to correct in the future. Congress and the president are responsible for fiscal policy, which is how government gets and spends money. Because they are elected officials, they represent and are accountable to American citizens. So they should provide leadership within the government for economic policy. The Fed is responsible for monetary policy, which is influencing the money supply. These two work in tandem to create the environment for our economy to flourish.

But Congress and the president have not been able to agree on a fiscal policy except fine-tuning on the margins. That has left the burden of preventing our country from a collapsing economy to the Fed. The Fed has had to use a huge volume of dollars pumped through their limited tools to have any impact. That has taken the heat off of Congress and the president, who are directly accountable to the people, and put it on the Fed, which is not directly accountable to the people. Should it be any surprise that there is little motivation by Congress and the president to get their economic act together?

My experience from two stints in public service is that the federal government is much better at dealing with micro issues (killing Somali pirates) than dealing with macro issues (healthcare). Government is a blunt instrument that is imprecise and usually causes many unwanted and unintended consequences. Unfortunately, QE is not an exception.

So has it worked? Maybe half a cheer, or even just jeers.

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