Economist's View: 'The Height of Fiscal Folly'
Noted for December 15, 2012

Another Person Who Thinks That the Fed's Policy Is "Risky", But Cannot Intelligibly Explain Why...

Muhammed El-Erian:

How risky is the Fed's major move?: A bold and necessary move? Yes, but the Fed's growing activism has limits and is ultimately inconsistent with the proper efficient functioning of a market economy.

Wow! That is what I suspect many investors said when they heard Wednesday's policy announcement…. Yesterday's Fed announcement will go down in the history books…. The Fed took two major steps on Wednesday, one expected and one less so. First, it added to its expected purchases of market securities, doubling the dollar amount to $1 trillion for 2013…. Second, the Fed shifted to quantitative (unemployment and inflation) targets for forward policy guidance…. This further leap into the policy unknown was motivated by continued disappointment with the economy's sluggish growth, persistently high unemployment and increasing concern about joblessness becoming more structurally embedded into the economy….

The bad news is that the institution, with its imperfect tools for the challenge at hand and with other federal government entities essentially MIA, may be taking on an unsustainable burden…. [T]he outcome of the Fed's unusual activism is neither predictable nor costless… an increasing risk of collateral damage and unintended consequences… ultimately inconsistent with the proper efficient functioning of a market economy. With a market share that will end 2013 between 30% and 45% depending on the securities, the Fed is heavily involved in markets as both a referee and player. As such, it distorts their functioning, the price discovery process and the allocation of capital….

This is not necessarily to say that the Fed should have refrained from doing what it did. Instead, it should be read as yet another very loud and clear message to our bickering politicians…. Let us hope that this new Fed window will be used well by Washington, and that Congress will finally step up to its economic management responsibilities. If this does not materialize, the economy could risk ending up in a worse place: failing to generate high growth and job creation, further hampered by market distortions and inefficient capital allocations, and having damaged the credibility, legitimacy and future effectiveness of the Fed.

Muhammed El-Erian appears to be working in a model in which there are "fundamental" prices of assets, in which the market approximates those fundamentals via some "price discovery process", in which those market prices than guide the allocation of capital, and Federal Reserve intervention in the market "distorts their functioning" especially when "the Fed is heavily involved in markets as both a referee and a player" holding "between 30% and 45%" of certain classes of securities.

But if that is Muhammed El-Erian's model, why have a Federal Reserve that engages in open-market operations at all? If open-market operations distort the functioning of the price-discovery process and lead to misallocation of capital, why not simply have the Federal Reserve put its hands in the air and slowly back away from the economy?

That El-Erian does not recommend the abandonment of open-market operations by the Federal Reserve suggests, to me at least, that he has not thought the issues through in sufficient depth.

Here is what I think is going on:

There is indeed a "fundamental" configuration of asset prices--one that produces full employment, the optimal level of investment given the time preference of economic agents and the expected future growth of the economy, and the optimal division of investment between safe, moderately risky, and blue-sky projects.

However, right now the private market cannot deliver this "fundamental" configuration of asset prices. The aftermath of the financial crisis has left us without sufficient trusted financial intermediaries to properly evaluate and grade the degree of risk--hence no private-sector agent can create the safe securities that patient and prudent investors wish to hold. The overleverage left in the aftermath of the financial crisis has left a good many investors and financial intermediaries petrified of losing all their money and being forced to exit the game--hence the risk tolerance of the private sector is depressed far below levels that are appropriate given the fundamentals of risk in the real economy and given the degree of diminishing marginal utility of wealth in the economy. Until this overleverage is worked off, the private marketplace left to its own will deliver (a) a price of safe assets far above fundamentals because of the artificially high demand for them by investors, financial intermediaries, and firms, (b) a price of risky assets far below fundamentals because of both diminished appetite for them and because many assets that would in normal times be regarded as safe are today regarded as risky, and (c) a level of investment and thus of employment far below the economy's sustainable and optimal equilibrium.

In such a situation, by issuing safe assets--and thus raising their supply--the government pushes the price of safe assets down and thus closer to its proper fundamental equilibrium value. The government can do this by either (I.a) having the Federal Reserve issue safe assets by buying risky assets for cash--monetary policy--(I.b) having the rest of the government borrow short and spend--fiscal policy--or (I.c) issuing loan guarantees--financial policy. Similarly, the government can shrink the supply of risky assets--and thus push their price up and closer to its proper equilibrium value--by either (II.a) having the Federal Reserve buy risky assets--monetary policy--or (II.b) having the rest of the government take on tail risk associated with risky financial assets--financial policy. If the government does this on a proper scale, it will push both the pure rate of risk-free time preference and the risk premium to their fundamental values. If it does this, then--even though market failures keep private financial intermediaries from doing their jobs--the government's actions will have driven asset prices and thus investment and employment to their optimum equilibrium values.

Quantitative easing--buying long-term risky Treasuries and MBS for cash--is a way of doing (I.a) and (I.b).

You can say it is not the best way because the securities the Federal Reserve is buying are not very risky, and thus a large value of transactions are needed in order to move prices even a little bit toward optimum fundamental values, and I would agree. (The response is that it is important that the Federal Reserve not appear to be "picking winners", and for it to start buying junk bonds or auto company equities or the Wilshire 5000 is for it to pick winners.) You can say that other policy tools--(II.b) or (I.b) or (I.c) are stronger and would be more appropriate, and I would agree. (But the response is that fiscal policy is now off the table because of the malfeasance of the Republican Party's congressional representatives, and that financial policy is off the table because of the Treasury's return of its TARP authority to congress and its keeping of Ed DeMarco at the head of FHFA.)

But you cannot say that the Federal Reserve's QE policies are distorting the price-discovery process and leading to a misallocation of capital. They are, rather, interventions in a price-discovery process that was broken by the financial crisis, that remains distorted due to overleverage, and that needs large-scale government intervention to repair its functioning, push financial asset prices closer to their fundamentals, and partially repair the allocation of capital and investment.