Numerous people are worried by Quantitative Easing but obviously most don't understand exactly what it really means and what are the risks. Those risks are more formidable than commonly thought

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Numerous people are worried by Quantitative Easing but obviously most, even some of the best economists, don't understand exactly what it really means and what are the risks. Those risks are more formidable than commonly thought

How Did we Get There?

The reason of the present crisis is the secular downward trend of the marginal return on investments as depicted by the chart of the 30 years US Treasury Bonds and the chart of the Yields of 10 Years US Treasury Notes.

When those return on investments were so low as to be below the fair price for interest rate risk banks have started to slow lending and/or made unprofitable investments.



The basic reason for those lower and lower rates of returns was not the absence of credit but a decrease of demand. As long as short-term yields were above zero the Fed could adjust supply and demand by lowering short-term rates. That of course ended when the short-term yields, the target discount rate became at or very close to 0%.

Here comes Quantitative Easing.

Purpose:

The intended purpose of Quantitative Easing is to bring down long-term yields, by lowering the yields of long-term treasuries in order to generate marginal investments.

The first thing we remark is that the crisis we are witnessing today is generated by excess investments in front of a deficit in demand. So bringing down the rates for the borrower is a very intricate scheme. The idea being to generate a sufficient flow of investments which hopefully will trickle down into sufficient demand. that in itself is convoluted. The very fact that demand decreased was due to the fact that not enough of investments trickled down to wages and consumption. Amplifying the phenomenon by tweaking the credit market is intuitively doomed to fail.

Why would you generate more of something you have already too much of? If you are fed up will more food make you more hungry?



In effect tweaking the yield curve has already been done, In Japan during the lost decade (which is 18 years old now) but also by the Fed in the 60's in what was called Operation TWIST. It resulted in a formidable and costly failure which caused the abandon of the Gold Standard.

Even with sound credit-risk management, a sudden widening of credit spreads could result in unanticipated losses to investors in some of the newer, more complex structured credit products, and those investors could include some leveraged hedge funds. Risk management involves judgment as well as science, and the science is based on the past behavior of markets, which is not an infallible guide to the future.

In anyway without a prior increase of demand it is difficult for us to imagine that the increase of investment will be sufficient to trigger a magical recovery. The answer could be that the Fed would buy corporate debts, then we can ask ourselves what is the limit? The Fed could end up owning all the debt of every corporation in the USA. PIMCO has already suggested that the mortgage market should be nationalized! That would mean that the credit market would be nationalized or at least its risk, which would mean that it is the Fed that would decide which corporation deserves to get credit and will live and which one does not and will die (Lehman Brothers vs Citi Group).

How Long Can Doctor Bernanke Run the Show?

The Limits of Doctor Bernanke; I have since 1994 predicted the inevitable collapse of the capital market what I have not predicted was the size, the brutality and injustice of the non conventional measures of Doctor Bernanke.

In fact we are already as most of market participants have noticed in a new phase of non conventional monetary policy: not only does the Fed buy long dated Treasuries it buys also all sort of different investment vehicles:

The Deflation Bias and Committing to Being Irresponsible by Gauti B. Eggertsson of the Federal reserve Bank of New York:

Abstract: I model deflation, at zero nominal interest rate, in a microfounded general equilibrium model. I show that one can analyze deflation as a credibility problem if three conditions are satisfied. First: The government's only policy instrument is increasing the money supply by open market operations in short-term bonds. Second: The economy is subject to large negative demand shocks. Third: The government cannot commit to future policy. I call the credibility problem that arises under these conditions the deflation bias. I propose several policies to solve it. They all involve printing money or issuing nominal debt. In addition they require cutting taxes, buying real assets such as stocks, or purchasing foreign exchange. The government "credibly commits to being irresponsible" by pursuing these policies. It commits to higher money supply in the future so that the private sector expects inflation instead of deflation. This is optimal since it curbs deflation and increases output by lowering the real rate of return.

What it means is that the Fed is slowly, secretly and unobserved buying all the investments vehicles in the US economy that is, if I am right, called in other countries rampant socialism. It means that it is the Fed that will ultimately bear the investment risk and hence decide what business will deserve to live and receive credit and which will deserve to die and will not receive credit. Marx and Lenin didn't do anything more and nothing less. The only notable exception is that it is the owners of the Corporations that will ultimately receive the dividends while the Fed will bear both the systematic and specific risk! The privatization of the profit and the socialization of the risk!

Of course that nationalization of the capital market is not the intention of Doctor Bernanke he is optimist and believes he will, once the illness is cured, unload his balance sheet. But how much of his $2 trillion balance sheet has he unloaded since he started his Quantitative Easing adventure: Zilch!. What is the size of his off balance sheet obligations: the amount of loans he has already explicitly guaranteed? The definition of insanity is doing the same thingover and over again and expecting different results. An optimist is a misinformed pessimist.

One of the expected advantage of buying stocks is to create, it is hoped, optimism in the future state of the economy.

In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market.

Fed Engineered Asset Price Bubble:

That is ill founded. Optimism in the economy is meant to make people who have money spend and invest. But you can spend and invest what is in your pocket. It is rare, I am told, that optimism will entice you to spend the money you don't have except in the case of the Irrational Exuberance of the bipolar in manic stage, which are statistically not numerous enough to jump start an economy.

The market will soon find out that there is no risk in buying stocks of established companies (mainly the companies included in the SP500) That will create a moral risk and some sort of irrational exuberance. With interest rate at 0% the present value of those stocks could reach stratospheric values in a very short period of time.

We know that Asset Price Bubbles are not Without Dangers:

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.

Our day-by-day experiences with the effectiveness of flexible markets as they adjust to, and correct, imbalances can readily lead us to the mistaken conclusion that once markets are purged of rigidities, macroeconomic disturbances will become a historical relic. However, the penchant of humans for quirky, often irrational behavior gets in the way of this conclusion. A discontinuity in valuation judgments, often the cause or consequence of the building and bursting of a bubble, can occasionally destabilize even the most liquid and flexible of markets. I do not have much to add on this issue except to reiterate our need to better understand it.

I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms,

Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity (myself especially) are in a state of shocked disbelief.

Waxman: Do you feel that your ideology pushed you to make decisions that you wished you had not made?

Greenspan: Well, remember what an ideology is: it is a conceptual framework about the way people deal with reality; everyone has one; you have to; to exist you need an ideology. The question is, whether it is accurate or not. What I'm saying to you is, yes, I found a flaw. I don't know how significant or permanent it is. But I have been very distressed by that fact.

Waxman: You found a flaw in the reality? (!!!??)

Greenspan: I found a flaw in the model that I perceived as the critical functioning structure that defines how the world works.

Waxman: In other words, you found that your view of the world, your ideology, was not right, was not working.

Greenspan: Precisely. That's precisely the reason I was shocked because I had been going for 40 years or more [on this model] with very considerable evidence that it was working exceptionally well

Conclusion:

I pronounce officialy the death of the free market capitalist economy if not of the capitalist economy.

We have no hope that those eggheads at the Fed and at the Treasury will ever change their Ideology and lead a policy contrary to the special interest groups and vested interests they defend and understand that credit is the least critical systemic linkage of the economy. The most critical systemic disruption comes from the lack of consumption capacity of the ordinary folks. We know they will continue to deseperatly pump the liquidity pipe in order to try to revive investments when it is the last thing this economy needs: it is precisely why it is called a Liquidity Trap.

This is why we offer the possibility for anyone to create in parallel to this prevalent economy, incremental jobs, consumption and later and less urgently investments:

Innovative Credit Free, Free Market, Economic Ideology
A Tract on Monetary Reform

Disclosure: No Positions

Authors Website: blog.cantona.me

Authors Bio:
I have an engineer diploma from Ecole Centrale de Lyon (France) and a MBA from Boston University. Since 1986 till 1994 I have worked as a broker dealer on the French Domestic Fixed interest market.

Since the spring of 1994 I have worked on the fact that the secular downward trend in long-term yield would, at some point, bring a market crash.

I have resolved the famous Greenspan Conundrum as I discovered that long-term yields decrease with the increase of income/wealth gap. Hence income distribution is an important factor of macro economic development.

I have developed a model of the yield curve that describe long-term yields as options on shorter term yields.

My conclusion was that when a "inverted' yield curve, as it would necessary be, would return to its fair value it will trigger a market crash which under the circumstances of a 0% short-term interest would be of major consequences.