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Parroting Supply and Demand: Department of "Huh?!"


Myron Scholes appears not to understand the basics of supply and demand:

Guest Contribution: Myron Scholes on Whether QE2 Will Work: Myron Scholes, the Nobel Prize-winning retired Stanford University finance economist, contemplates the prospects for another round of Federal Reserve quantitative easing, and wonders if it’ll work as well as the Fed hopes.

Some possibilities:

(1) Maybe in short run, QE reduces the risk premium and encourages investment. Encouraging investment is good. The problem is that this isn’t a rational argument. The risk premium can’t be affected by flows. Investors will sell risky assets to government and buy bonds. The Fed could end up holding all risky assets; investors will hold safe assets. The risk premium stays the same...

If the Federal Reserve holds all the risky assets, then the risk associated with them is borne by taxpayers as a whole.

Taxpayers as a whole are different from investors as a whole.

Thus if the Fed buys risky assets for safe assets, it reduces the quantity supplied of risky assets to be held by private investors. As quantity goes down, price goes up. As the price of risky assets rises, the spread between their expected returns and those of safe assets goes down.

In other words: the risk premium does not stay the same. It goes down.

This is not rocket science, people.

I can still hear Milton Friedman:

Brad. Supply and demand curves are never horizontal. They are never vertical. If somebody says that quantities change without changing prices, or that prices change without changing quantities, hold tightly onto your wallet--there is something funny going on.

To claim that shifting risk off of investors and onto taxpayers has no effect on risk premia because "U.S. persons own the Fed.... society still has the risk. The risk doesn’t go away, any more than the risk of holding subprime mortgages went away before the crisis. We cannot structure the risk such that it disappears..." is the kind of mistake that--well, that not even a parrot would make.

We can (and do) argue about how much quantitative easing would reduce risk premia. But the assumption that the relevant demand curve is flat--that seems to me to be a mistake that a properly-trained parrot would not make.