QE2, inflation, deflation, bubbles and busts and crashing planes, and Anton Chigurh

November 7, 2010

Back in 2001, the Federal Reserve began slashing interest rates as the economy slumped into a recession. The objective was clear: counteract the deflationary pressures of the imploding Nasdaq, pump money into the markets, increase velocity, reverse disinflation, get the economy moving again, bring us back to GDP growth and full employment.

The strategy was successful. By 2004, core inflation was on the rise. The FED manged to push the interest rate below the inflation rate, so real rates were actually negative. This induced copious amounts of lending (as Bloomberg notes, US consumers took on $2.9 trillion in new home-loan debt from 2004-2006, the biggest increase of any three-year period on record). Velocity rose. GDP grew. We achieved full employment. The economy was back on track.

But we also created massive bubbles in housing, stocks, and commodities — all of which burst when the FED attempted to throttle the economy by raising interest rates. As the FED withdrew money, the ponzi-scheme bubbles were starved of the necessary new ammo (i.e. fresh money) to keep them going. As such, the bubbles collapsed spectacularly, sending the economy to the brink of worldwide financial destruction.

Fast-forward to autumn 2008. The economy was crashing. Deflation was a real risk. The FED went back to the monetarist playbook: drop interest rates, pump money into the markets, fight disinflation, induce lending, etc. And when the FED hit the interest-rate zero bound, it pumped even more money into the economy with “quantitative easing” — printing money to buy treasury debt directly.

Two years later, the real economy is still slumping. Deflation is still a risk. So last week, the FED announced a second round of easing, dubbed “QE2”:

In its latest move to jump start the sluggish recovery, the Federal Reserve announced it will pump billions into the economy.

The central bank will buy $600 billion in long-term Treasuries over the next eight months, the Fed said Wednesday. The Fed also announced it will reinvest an additional $250 billion to $300 billion in Treasuries with the proceeds of its earlier investments.

QE2 is a further attempt by the FED to raise core inflation back to a meaningful target, which Paul Krugman explains, is somewhere near 4%.

Meanwhile, stocks are rising. Commodities are rising. Bonds have nearly reached their own “zero-bounds”.

It seems the FED’s hope is that all the additional money it drops from helicopters will fall across the economy evenly, thereby generating an even amount of inflation everywhere — most importantly in core inflation. But in reality, the money is directed by selfishly rational economic actors, who have not much care for the economy’s overall health. They only care about profit, and as such they will direct the money where the likelihood of profit exists. The real economy, currently suffering from overcapacity, isn’t offering much in the way of profitable investment. So the actors search elsewhere, poking and prodding, looking for the next “sure thing”. Eventually enough of these actors poke and prod in the same direction, and suddenly profitable investments re-emerge. Over the last year-and-a-half, we’ve seen feverish poking at stocks and commodities. Since the March 2009 lows, the S&P 500 has risen 85%, while commodity indexes are up 50%. The “sure bets” are back in sight. Money managers are making money again. The financial industry is happy.

And yet the real economy limps along, getting nowhere. Even the money that actually reaches the hands of the middle class, eventually gets absorbed by the financial industry, as the middle class services all the mortgage and credit-card and student-loan and car-loan debt it piled up over the last decade. As we continue to trend toward core deflation, the FED will no doubt feel justified printing ever-more money. It’s simply following the basic rules of monetary theory: deflation = high demand for money => print more money.

I am not too sure, but it seems to me that we have at least a 50/50 chance (probably greater) of repeating the destructive, ever-worsening bubble-bust pattern that has plagued the worldwide economy for the last 3 decades. John Hussman has recently stressed the dangers of excessive quantitative easing here, here, and here. Paul Krugman thinks we shouldn’t worry about bubbly inflation too much — deflation is still the real threat. And Bernanke says, “I don’t know what you guys are talking about, I’m not even TRYING to create inflation.”

Bernanke reminds me of a pilot, desperate to maintain airspeed in order to sustain lift. His rule is straightforward: we must go fast, lest we fall from the sky. But as he blindly follows the rule, he ignores the fact that the plane is violently pitching up and down, lurching left and right, as it encounters severe turbulence that’s only made worse the faster it goes. On the one hand, Bernanke’s right: if we slow down, we might fall out of the sky. But on the other hand, if the turbulence gets too extreme, the plane might break apart in mid-air. We’ve already suffered some serious damage. The passengers are getting pretty banged up. The fuselage is dangerously unstable. The airframe is critically strained. The next shock might be perilously intolerable… But Bernanke thrusts ahead. He’s not going to let this plane drop from the sky. He read about the great de-lifting of the 1930’s. He’s not about to let that happen again. Not on his watch.

But what if crashing to the ground isn’t the worst thing that could happen? What if mid-air disintegration is a far worse fate?

Bernanke’s steadfast abidance of the rule reminds me of the icy wisdom that the diabolical Anton Chigurh shares with his rival — the more conventional-means bounty hunter Carson Wells — just before Chigurh blows him away:

If the rule you followed, brought you to this, of what use was the rule?

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3 Responses to “QE2, inflation, deflation, bubbles and busts and crashing planes, and Anton Chigurh”

  1. Jørgen Says:

    Your airplane analogy is good, but I think it can be taken further. The primary problem isn’t turbulence, but that the plane has developed an undersized engine and an oversized passenger compartment. A plane like that is only capable of flying slowly, and even slower if it needs to climb.

    Every time the stall speed warning has gone off (the economy has slowed down), the Fed has done what every good pilot would have done. It has put the plane into a dive, by adding more money to the system. This makes the plane (economy) go faster, at the expense of altitude. As long as we were sure we were high up, higher than anybody else, this didn’t seem to matter. We stayed focused at airspeed (GNP), not altimeter (national debt).

    Today, we’re painfully aware that China’s engines are getting stronger and stronger, while ours are due for a major overhaul. That has caused a lot of simple-minded people to go bananas over the way the altimeter is spinning backwards … to the point where they’re willing to pull the stick backwards and jerk the whole thing into a tailspin. If they do, it will be the end of America as we know it.

    Every time we’ve piled up more debt, we’ve given power to our creditors: Power that we’ll no longer have to solve our own problems the way they should have been solved in the first place.

    Right now, with the stall-speed warnings blaring all around us, I support trying to jump-start the economy once more by putting the plane into yet another dive. This is something we can’t afford to NOT do.

    However, the only thing that can get the aircraft back in airworthy condition in the long run is to drop dead weight overboard, focus all remaining engine power on actual propulsion, and put all available manpower and talent to work improving the system.

    The idea that freer markets and even lower taxes will solve this spontaneously, is ridiculous. If left to their own devices, most passengers will continue to spend their energy on useless luxury items or personal “profit”. In today’s speculation-driven economy that means buying some more or less useless asset in the hope that someone else will pay more for it another time (=asset price inflation).

    We need leadership. We need to drop doing things that don’t work.


  2. My concern with the dive approach is that it assumes air will flow over the wings evenly. This is of course true for a real plane. But I think our bubble problems are evidence that waves of new money do not flow over the economy evenly. Instead those waves pile into ponzi investments (the asset inflation you mentioned), growing ever larger until they crest and crash.

    I found Hussman’s 10/25 article particularly interesting. He talks about the ineffectiveness of monetary policy when the economy is in a liquidity trap resulting from capital overcapacity. In such times, lowering rates to induce further capital investment may be counterproductive:

    “Following the monetary intervention, relatively easy money provides a greater incentive to order capital… But now the overcapacity that characterizes the peak in the production of capital goods reaches an even higher level than without the stimulus. This overcapacity eventually makes further investment even less attractive and causes the decline in capital output to proceed from a higher peak and at a faster pace. Due to persistent excess capital which cannot be reduced as fast as labor can be cut back to alleviate excess production, unemployment actually remains higher on the average following the drop in production.”

    In our current state, I believe fiscal policy — i.e. direct govt stimulus — rather than monetary policy would be much more effective at increasing our airspeed, and far less likely to create further turbulence (ponzi bubbles).

    Of course, this strategy must overcome the republicans’ new-found desire for austerity. Hopefully that was simply an election-season campaign ploy, and now that they are back in power, they’ll return to their mid-2000s form and spend spend away.


  3. […] morning’s reading of Rob Alderman’s blog made me think of another analogy of the economy. Your airplane analogy is good, but I think it can […]


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