I believe that the policies we have undertaken have been meant to generate a robust recovery.1
Effective demand is dead in the water.2
Quantitative easing…is that, like, making math easier?3
Well, goodbye to all that. Until the next time, Quantitative Easing.
For normal people with more interesting lives, I imagine articles headlined with the words “quantitative easing” prompt a mild degree of nausea and / or disinterest. As for me, for the last six years4 I’ve found it hard to avoid reading pieces on the unparalleled series of unconventional monetary policies: QE 1, QE 2, Operation Twist, QE 3. So much juicing of the financial markets, so much time I will never have back, so many unintended consequences nobody can foresee.
Reading the FT whilst sipping my morning coffee—as is my wont—last week, I saw an article that literally had me jump in my seat, “Debate rages on quantitative easing’s effect on inequality.” Debate? Rages? “Surely this is a joke,” I thought. Yet sure enough, there in print, were deflections and evasions from central bank officials on the question of QE’s culpability for increased inequality. I had to double-check that I was, indeed, reading the FT and not a transcript of Bird & Fortune.
How is this a question?
Reasonable people can disagree over the merits, scale, frequency and duration of QE policies. The hypotheticals of what would have happened to the global economy without 3.5 QEs are irrelevant — nobody knows the answer. The ultimate impact on the real economy seems to have been muted, as here we are six years later facing feeble aggregate demand. The impact on financial markets, however, has been profound.
And here is where we come to the irrefutable fact: QE increased inequality. How do we know? By looking at inputs, initial conditions and outcomes.
Inputs: Trillions of Dollars and The Wealth Effect
Since early September 2008, the Federal Reserve’s balance sheet has increased by roughly $3.6 trillion (an increase of ~4x in size). In its quest to ease financial conditions and thus stimulate the economy, an explicit objective of the policy was to increase asset values (e.g., prices of homes and financial assets) and create a “wealth effect,” which basically means people feel richer5 so they buy more stuff.6
It might be helpful to think about how this policy impacts asset values in two stages: the first technical, the second psychological. For simplicity, we’ll just focus on bonds and stocks, and leave out the agency debt and mortgage-backed securities activity (see exhibits below at right; click to enlarge).
Stage 1 – The Alchemy of Finance
So under quantitative easing, the Fed literally bought U.S. Treasury bonds, which—all things equal—leads to an appreciation in bond prices (because more demand increases prices) and a reduction in interest rates (because bond prices and interest rates move in opposite directions).7 Since U.S. Treasurys are frequently used as a reference and discount rate for other securities, what this policy effectively did was bring future earnings / return streams forward to the present. Bond and stock prices went up—catalyzing that wealth effect—and interest rates went down.
And this is great, in a way. It reduces the cost of borrowing (the “cost of capital”) which means—in theory—that firms generally face lower hurdle rates on their investments and reductions in their interest expense (which can free up working capital and whatnot). So basically, the theory goes, banks will lend more money, and companies will take advantage of these easier financial conditions to invest, create jobs, and drive the economy forward…they will create value. Or, you know, an executive can issue relatively cheap debt in the capital markets and use the proceeds to buy back shares to juice his / her own stock options. Such is the alchemy of finance.
Stage 2 – Animal Spirits
In the years to come, academic economists will spend countless man-hours running regressions and hypothesizing correlative and causal relationships between QE and asset prices. Maybe one day there will be a data point proving it all.8 In practice, QE—and QE 3 in particular—morphed investor psychology. The growing awareness of a “Bernanke Put” prompted a ravenous search for yield that has pushed U.S. stocks to all-time highs, and led to zany behavior in every corner of financial markets. The list of examples would be too long to include here.
Initial Conditions: Cui Might Bono?
Now, to get a sense of who would benefit from a policy in which stock and bond prices would appreciate in value, it helps to know who owned stocks and bonds ex ante. Every three years since 1983, the Federal Reserve has run a Survey of Consumer Finances. The most recent survey was in 2013.
Before the world economy nearly imploded, it was fairly clear who might benefit from an inflation in asset prices. The Fed’s survey data of asset ownership in 2007 show that those who were in the top 10% of incomes, those who had college degrees, and those who were white were most likely to enjoy the wealth effect (see exhibits below; click to enlarge).9 As Tom Friedman might say, a rising tide lifts all boats, but some boats are more equal than others.
Outcomes: Rich Got Richer, Everyone Else Stood Still or Fell Back
How’d we do, team? Since data were missing from the Fed’s pooled investment fund segment, I’ve focused on the performance of retirement accounts (see exhibit below; click to enlarge). As expected, those in the top decile of incomes and white people were more likely to come out ahead. With respect to education, those who had at least some college education were likely to benefit.
Just in case one thinks I’m cherry picking, here are some charts from a separate study by the San Francisco Fed, which uses Census Bureau data over different time periods to show similar issues.
Some people—such as the author of this Wall Street Journal article—have pointed to poor decision-making amongst poorer households as an explanation for this outcome. They simply sold at the bottom of the market; if only those idiots had bought stocks at the bottom instead, they would have had more money today. Or so the thinking goes, I guess. If you’re one of those who sold at the bottom (or missed out on the bonanza), how does that stick in the eye feel?
While the study that the Journal article covers apparently controls “for job loss or mortgage distress,” I wonder whether it covers the many other reasons individuals find they need cash to meet current liabilities; say, to pay for medical bills or finance a child’s education…you know, some of the reasons why people invest in the first place. I also wonder whether it glosses over the degree of economic hardship besetting a large swathe of American families. This Washington Post article, for example, relays that 25% of American workers with a 401(k) either withdraw cash from or take loans out against their retirement savings to meet current expenses.
Not to suggest it’s related to QE, but this is quite the kicker. If you exclude the wealth effect, and just look at how incomes have fared over the last few years, the only people who haven’t experienced a real decline in earnings are those in the top 10% of incomes. There is a fair bit of data in the table below; I would simply draw your attention to all of the minus signs in columns four and seven before one comes to the top decile of incomes.
Who’s to Blame?
It’s easy to blame the Fed for all this inequality, but it’s not entirely their fault, and it’s certainly not their job to fix it. In the face of a depression, deflation and massive deleveraging, they saw a need to keep the foot on the accelerator. Where, one might wonder, was the fiscal side in all of this?
I think most would agree that Congress has done little to nothing with the fiscal lever of policy at a time when borrowing costs have been quite low. Those who are angered at the inequality birthed by QE may wish to consider why Congress has refused to pursue expansionary fiscal policies that could have put more people to work, provided long-term structural competitive advantages for the United States, and bolstered aggregate demand.
Or perhaps consider why Congress has not debated whether a modicum of redistribution from capital gains might be appropriate given the fact that QE would inherently exacerbate inequality in a way that brought rewards not for hard work and creating value, but simply for those citizens who owned assets to begin with. Statesmen and citizens alike might wish to ponder whether this is a just outcome befitting of the society in which they wish to live.
The riskiest thing in the world is the widespread belief that there’s no risk…While investor behavior hasn’t sunk to the depths seen just before the crisis, in many ways it has entered the zone of imprudence…Today I feel it’s important to pay more attention to loss prevention than to the pursuit of gain.10
We’ve never had any experience with anything like this, so I’m not going to sit here and tell you how this will turn out…I don’t think it’s possible [to exit QE without turmoil]…[When real interest rates go up, for whatever reason] it is basically [going to be] a very significant decline from an extraordinarily elevated equity premium.11
If you managed to benefit from QE, congratulations! As the data show, many of your fellow citizens didn’t, so be grateful. I was not 100% fully invested in stocks for the duration of QE so I missed out on some free money. Tant pis. Couldn’t care less, really.
Yet as QE has come to an end in the United States, market participants’ appetites appear far from sated. You can see the addicts circling around other central banks, penning editorials imploring the European Central Bank’s Mario Draghi to embark upon a quantitative easing program to fight off deflation. The Bank of Japan has just delivered another potent hit of its own QE, so maybe the madness will continue. And who knows? Maybe Japan will export their deflation in the process, stirring calls for more QE here in the United States.
Addiction is a disease, after all.
The Reckoning | January 2014
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1 Federal Reserve Chair Janet Yellen, 14 Nov 2013.
2 Former Federal Reserve Chairman Alan Greenspan at the Council on Foreign Relations, 29 Oct 2014.
3 Name has been withheld to protect the innocent.
4 Six years!
5 Like, you actually have to sell your assets at some point to realize capital gains and actually be richer.
6 Psychology (or “behavioral finance”) plays a big role in all of this mumbo jumbo.
7 Look, this is more complicated in reality. During the various QEs, rates actually rose, but over its duration, rates have gone down. Nobody really seems to know why what happened happened. It’s all a bit slippery here, but let’s just keep going.
8 Maybe there already is!
9 Another angle would be age, but since I’ve covered this territory previously, I will simply share this quote from the Bank of England’s Andrew Haldane: “A financial boom is, in effect, a generational power struggle. The beneficiaries from an asset boom are today’s asset-owning older generation. Vocal and voting, they are a powerful coalition. The losers from an asset boom are today’s younger of future generations who face costlier assets or larger amounts of debt to repay. Yet they are often neither vocal nor voting. Many will be unborn. They are a weak coalition. This generational imbalance of power may generate an inherent pressure to expand credit and inflate asset prices. The financial system may have in-built tendencies to create credit and asset booms, to enable the transfer of resources from tomorrow to today, from the young and unborn to the old, from the silent to the vocal. Yet, longer-term, this is another myopia trap. Indeed, as it is effectively a transfer from the pockets of our children and grandchildren, it is the ultimate deceit.” See: Why institutions matter (more than ever), 4 Sep 2013.
10 Howard Marks, “Risk Revisited,” September 2014.
11 Greenspan, op. cit.