Everyone is talking about exit strategies, but what should be exited and when?  No consensus from economic wiseguys, just a recognition that this issue is utterly critical.

Fathom Consulting have a direct go at Conservative economic policy.

“While we agree that the UK’s fiscal position is dreadful, Opposition plans to begin fiscal tightening next year could spell disaster. We are calling for an overhaul of the Bank’s QE programme to make it start delivering for the real economy: for all firms, not just the biggest; and to provide a cushion for cash-strapped households.”

This reminds me of Slash and Grow, and the conclusions on QE are similar to those I would make: focus QE better on the real economy, do less of it, don’t dismiss fiscal policy but use QE to support it.

Hamish Mcrae’s answer is to start thinking about exiting BOTH fiscal and monetary support, and by 2010.

What is clear is that QE has to end soon. Once growth is re-established, there can be no justification for continuing it. . . . Behind all this is a bigger question. It is to what extent is the present recovery – first, in financial markets and, now, in the real economy – an artificial creation of exceptional policies? It is a fiscal issue – how far, for example, was the American growth the result of the US government’s boost? And it is a monetary issue – how far have house prices here recovered merely on the back of QE? So when these policies are withdrawn, and I have seen no suggestions they can continue beyond 2010, will there be self-sustaining growth?

But Roger Bootle says More QE, and it’s good for us.

As far as things over which we have control are concerned, all we have is QE. It is without doubt a dangerous policy. The far bigger danger, though, would be to do nothing, allowing the recession to continue and the economy to sink into deflation.

Whereas Wolfgang Munchau says we must NOT be too late in preparing the Big Exit from . . . QE.  But in the meanwhile, fiscal policy is the more effective.

Some recent economic research** has shown that stimulus programmes are particularly effective when interest rates are very low. It is no surprise therefore that even fiscal conservatives, like the Germans, are now borrowing as if there is no tomorrow. As the world economy heads into a still uncertain recovery, this is not the time to apply the fiscal brakes. But it is perhaps time for a moderate monetary tightening.

So QE is helpful because it helps fiscal policy.  But is it risky?  Roger Bootle thought not: it can be easily reversed.  Richard Koo in his excellent book pointed out the hugely inflationary risks of the policy, while finding it utterly inert in the case of Japan when there are no willing borrowers.

Personally, I doubt the inflation risks while the output gap is so large.  But the risk of asset bubbles – you know, those things that got us into all this mess – is bigger.  Unsurprisingly, Nouriel Roubini is the most worried of all.

the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – . . . So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles . . . the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

What is my verdict on all this? 1.  I think QE really is riskier than Mervyn King lets on  2. I think fiscal policy has unusual traction for the next year or two whereas QE itself is potentially intert on demand, at least directly 3. I think QE has economic effects but they are little understood, and the mechanism of causing an asset bubble to boost demand is not a very good one 4. Now that it has happened, unwinding it quickly might provoke a huge crisis and 5. it might have been better doing less QE but using it for more direct demand-changing operations.  Like funding a National Investment Corporation, perhaps?

A letter to the FT summarises point 2 very well.  Well said, Andrew Kilminster:

The events of the last year have amply confirmed Mr Bernanke’s insight that it is possible to have a situation where there can be a great deal of money in the economy but hardly any credit available.

David Heigham (see comments on last post) has done me a big favour by alerting the blog to the existence of the Levy Centre. Like Richard Koo, the authors of a recent piece of research believe that you can’t ignore the debt-situation (i.e. balance sheets) of households and non-financial businesses.

While Washington’s focus is on the staggering government debt and unsustainable fiscal deficits, the real concern should be the debt level of the private domestic sector. It is important to recognize that government debt is low relative to the size of the U.S. economy, and deleveraging in the private sector cannot happen without an expansion of the government deficit. Otherwise, there is risk of a full-blown debt-deflation process.


9 thoughts on “Something must end soon, but what?

  1. You tempt me to a tentative appraisal of QE:

    1. It is riskier than Mervyn King lets on; and so is fiscal expansion at the present rate. But he wouldn’t risk a possible overstatement of the risks, would he? Especially when the risks of doing without either are clearly greater than the risks of sticking with them.

    2. a) For fiscal policy to have unusual traction, the taxpayers must be implicitly expecting less than fully matching future fiscal pain. That seems ot be rational if current policy overall creates an expectation that we will be better able to bear the future fiscal pain because of its results. But the amount of extra traction is only significant if taxpayers aredeeply worried about what the situation would be without current policy. That will be decreasingly true (I hope), but it has been very true since the panic a year ago.

    2. b) Relaxing monetary policy, via lower interest rates or via QE, does not necessarily expand demand; it is “pushing on a piece of string”. Nor does it necessarily expand credit creation. However, QE does stop banks worrying about the liquidity available. Their worries about insolvency – bad loans and insufficient capital – remain; but they become much less panicky.

    3. a) My hunch is tha the SFC model will prove to be the means of getting our heads around the economic effects of QE.

    3. b) QE will only cause an asset bubble (or general inflation) if it is left in place too long, and causes an expansion of the broad money supply. QE has to be drained out as creation of credit goes back to nomal. That is essential: if QE is not drained out, our monetary base will be far to large for finacial stability. The draining may prove easy or difficult; but it would be prudent to expect problems (not least from political interference).

    4. Premature draining of QE from the system risks financial panic from our under-capitalised banks; see 2. b).

    5. Tempting as it is, turning QE into another sort of fiscal stimulus would mean that draining it out of the economy becomes even trickier.

  2. David, that is v interesting. I must admit that 5. is a poser: if the reserves posted into the system are 10X the amount that would be needed to support ‘normal’ banking activity, does it mean that we will get 1000% inflation when things return to normal? Or will future banking regulations prevent this from taking hold?

    Also, point 3a: are you sure we don’t have an asset bubble already in place? I agree about general inflation, but assets can misbehave more quickly.

    Particularly intruigued by 2a. I have been greatly influenced by Keynes/uncertainty (see the R Skidelsky book), and so find it hard to accept models that propose anything about investors future expectations. My own mental model has the taxpayers having at best a vague belief in the future fiscal pain, and an optimistic belief that for years 5-10 ‘something will turn up’, so that what matters to them is whether they will make it through the first four years. That requires some degree of certainty, and the positive effect of government spending – more jobs, more output – therefore outweigh the more difuse negative ones.

    I have a strong feeling that I need to buy the Godley book now

    1. Giles, Apologies again. got distracted and forgot I had not replied.

      There are two big steps betweem volume of reserves posted into the system and inflation. The ratio of leverage on the reserves – and therefore the amount of very broad money in circulation (not measureable, but a useful imaginary number here) – does not appear to be determinate in any proper analysis that I have seen. I suspect, but cannot begin to demonstrate, that a large increase in reserves will lead to a less than proportionate increase in broad money. Nevertheless, I am definite that it is likely to lead to some substantial increase. Second, much of our monetary economics implictly assumes something like a constant velocity of circulation of money at equilibrium. I see no reason to assume a constant velocity of circulation in any finite period (the period since the invention of money is a finite period). A priori reasoning would suggest that an imminent prospect of a large increase in the money supply would lead to an increasein the velocity as people flee from money towards other things more likely to retain value. That process leads to an unstable and accelerating rate of inflation. The odds that undrained QE on the current scale would lead to inflation are very high, but the odds against being able to predict how high are nearly as great. Future banking regulations are capable of restraining the inflationary process in some degree for some indeterminate time, but no-one has suggested regulations capable of preventing the process working.

      You see an current asset bubble in place and swelling (congratulations on your housing price bet; I did not think that QE would sustain house prices so substantially), I see old bubbles not yet fully deflated, and losses still unrealised. For future policy, I doubt if the implications of the two views are greatly different. As the barmaid said “Whether the glass is half full or half empty, sooner or later I am going to have to wash it.”

      (As an aside: I foresaw the late 1980s/1990 housing price crash, and pleaded for some measures which now look not unfamiliar to prevent it overshooting badly. Current experience convinces me that they were likely to have worked, at least partially. But I never conceived that policy might be strong enough to cause an undershoot.)

      My comments were about taxpayers’ expectations, not those of investors. The Keynes of the General Theory was, I judge, aware that taxpayers’ expectations might be important; but used his marvellous style to dance elegantly away from the issue. I myself think that people build a degree of resigned uncerainty into their expectations of what governments will do. Paradoxically and procyclically, that favours people spending money when they have it, and saving when they have less. Clear policy of any kind has the potential to reduce this uncertainty and reduce the corresponding volatility of saving and consumption. I think that the relative clarity of much of policy now – QE and spending – is helpful; and a fully coherent policy stance could do a lot more good. The more coherent and purposeful counter-recession policy is( i.e , , it ” … creates an expectation that we will be better able to bear the future fiscal pain because of its results.:”) the more it has traction. The degree of traction is better described as the difference between expectations with policy and without than by my loose refernce to the degree of fear present. I find that I have abandonned the idea that people’s real expectations concentrate exclusively on the first few years. Once you build in explicit uncertainty, short sight no longer seems necessary.

      1. David

        Lots to think about there. Your claim about the velocity of money moving upwards sounds logical: but seems to have been recently contradicted by events. It seems there are several unstable equilibria in terms of inflation expectations: one low, one high, for sure. Scott Sumner (blog “The money illusion” is interesting on this). But I found Brad DeLong’s Keynesian approach to velocity interesting:

        where it seemed to be just the same as Y in the classic IS-LM curve. In which case he imagines a flat curve when rates hit zero.

        So if no-one thinks the velocity will be high, it won’t be. Until everyone thinks it will be, then it will be. Very volatile and hard to control – not sure they have the levers.

        On Houses, I didn’t really foresee QE – just low rates, and i found it hard to imagine a panicked sell with rates at 3-4% and unemployment at 8%. Plus, the lack of supply was obvious: all those people who needed a house in 2006 had not gone anywhere.

        I think the CPS has something coming out about QE – would love to know what you think about it.

  3. I think that the problem is that virtually all economists, with a few exceptions on the fringes, have an insufficient appreciation of how the monetary system intersects with the real world.

    There is a fundamental difference between credit which is:

    (a) Dynamic – being the credit necessary for the circulation of goods and services and the creation of productive assets; and

    (b) Static – being legal claims over productive assets such as mortgages and shareholder rights.

    The fact that credit intermediaries are not necessary for the former is demonstrated by the existence of the Swiss WIR system, where tens of thousands of Swiss businesses exchange billions of Swiss Francs’ worth of goods and services on credit terms not FOR swiss francs as fiat Units of currency, but BY REFERENCE TO swiss francs as a unit of measure, or what I prefer to call a Value standard.

    ie credit intermediaries may be conventional, but are not in fact necessary.

    QE is essentially replacing static credit which has formally or informally become non-performing. In the absence of such QE we would see deflation and depression.

    We have essentially sewn up the visible wounds in the patient – from the visible banking system – but the patient is still bleeding internally from the vast – and increasing (further waves of defaults are on the way) – pool of credit created by the shadow banking system.

    QE is essentially a transfusion, and must continue in the absence of surgery. The only surgery which would work IMHO is a debt/equity swap, as Buiter and Taleb are now saying, for instance.

    Any proposals to cut spending, unless counterbalanced by investment, would be equivalent to applying leeches to the patient.

  4. Chris,

    From differnt starting points we seem to be converging on a similar diagnosis. As for treatment, would not any form of large scale recapitalisation of the banks be likly to work?

    Thanks for the mention of the Swiss WIR system. Getting to grips with how it works has been pending buisness for me for decades. In general on credit created without intermediaries, there is a vast unmeasured volume in every economy I have met. That is one of the reasons that money supply measurements are fundamentally inadequate.

    Leeches are used in modern medicine to remove dead matter. Spending cuts right now would hurt because the would bite on the live parts of the economy; they would be far worse than applying leeches.

    1. Chris

      Sorry for a dumb question. But are you this chris cook as well?


      Not sure I see the same essential differences in financial capital. Or rather, they strike me as similar to those that have existed for centuries. Bills of exchange and mortgages. Most economic historians e.g. Larry neal my old prof have long thought that Bills of Exchange were useful and necessary innovations

      1. Not me. Too many Cooks 🙂

        There is nothing new under the sun. My risk-sharing proposal for circulating credit/working capital is essentially to monetise trade credit (ie bills issued by businesses) within a framework of trust I call a ‘Guarantee Society’.

        The WIR achieves a framework of trust in respect of debit balances through the use of a charge over WIR members’ property.

        The new forms of revenue/production-sharing partnership equity I am working on have been around for thousands of years. They are in fact Islamic Finance as it should be, rather than the sophistry which currently applies an Islamic veneer to a, distinctly unIslamic reality. There is no such thing as Islamic ‘gearing’ or ‘leverage’.

    2. I don’t think any form of recapitalisation will work, including nationalisation, because there is a fundamental lack of creditworthy individuals, projects, and enterprises.

      Leeches are used to bleed patients, which is the last thing needed when he’s bleeding already, of course. I think you confuse leeches with maggots, which are indeed used to cleanse wounds of dead matter.

      Maybe the maggots are the insolvency practitioners?

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