Martin Wolf: Living in Lehman’s Shadow: Noted
Ambrose Evans-Pritchard: My grovelling apology to Herr Schäuble: Noted

What Are the Costs to Extending QE Anyway?: A Challenge to Cardiff Garcia


Toward the end of an otherwise very good think piece (i.e., a think piece that quotes my weblog favorably), the intelligent and thoughtful Cardiff Garcia mysteriously writes:

But the downsides to continued QE aren’t trivial either.

Which makes me ask: what are the downsides to continued QE?

The Federal Reserve buys long-term Treasury debt. The private sector has no less amount of safe U.S. government liabilities to serve as collateral--in fact, the cash or that short-term Treasuries now in private hands are better collateral for cash than the long-term Treasuries. The Federal Reserve now bears some short-term risk, but not if it holds the securities to maturity--which it will. The Federal Reserve has thus promised that it will not let the money stock fall below its long-term Treasury holdings until they mature, which adds to certainty and removes deflation risk. The private sector's limited risk-bearing capacity thus has a reduced quantity of duration risk to bear, and that risk-bearing capacity can be turned to bearing the risks of investment and enterprise.

Everybody wins!

Or, rather, nearly everybody wins: people who were in the business of bearing duration risk find that the returns to bearing duration risk are lower, and thus that their institutional capital in the form of expertise as to how and in what manner to bear duration risk has been impaired in value by the Federal Reserve's policies. But are those who are in the business of bearing duration risk more morally virtuous than those who are in the business of starting-up risky businesses or selling their labor-power for money? Is there a reason why Federal Reserve policy should be tuned two notches toward enriching those in the business of bearing duration risk and impoverishing those in the business of starting-up risky businesses or selling their labor-power for money?

A world in which U.S. equities currently have an earnings yield of 6%/year does not appear to be a world in which there is ample risk-bearing capacity going begging in the marketplace. If there were, there might be an argument that the Federal Reserve's pulling Treasury duration risk out of the marketplace increases the risk of bubbleicious overleverage by feckless risk-lovers. But if there are feckless risk-lovers, why haven't they bid equities up to more substantial price-earnings multiples? I fear bubbles in real estate, in equities, and in commodities. But is Cardiff telling me that I should fear bubbles in… bonds, which have a terminal maturity date and value that pins down their value not in some infinite transversality-condition long run but in 2023?

I thereby challenge Cardiff Garcia: Explain to me just what is meant by the claim that:

The downsides to continued QE aren’t trivial.

And if, Cardiff, you meet not this challenge, I name you caitiff, and offer you slight regard!

Cardiff Garcia: When the ill-defined problem meets the unproven solution:

Many, many commentators noted after the August employment situation report that the unemployment rate has dropped in recent years largely because of a decline in the labour force participation rate…. If the demographic-adjusted decline is predominantly cyclical, then we can expect workers to return to the labour force if jobs growth were to accelerate. In that case, the rapid decline in the unemployment rate has been sending an inaccurately hopeful signal of labour market health. Perhaps we should be looking more closely at employment-to-population ratios for different demographics. A decision by the Fed that would be interpreted as a tightening of policy might therefore be premature now…. The difference between structural and cyclical isn’t always clear, with no single point where one ends and the other begins…. This is also where it’s tempting to write that the truth is likely somewhere in the middle. But actually we don’t know where the truth is….

Work that supports the cyclical case in this dispute has been done by IMF economists Christopher Erceg and Andrew Levin in addition to economists from Goldman Sachs and the San Francisco Fed. On the other side are Chicago Fed economists, Mitra Toosi of the BLS, and John Williams (citing work by Toosi). Which brings us to the most recent exchange…. Gavyn Davies[:]….

Until recently, I thought the Keynesian view had been fairly strongly supported by the published empirical evidence [1]. Lately, though, I have been increasingly concerned that some or all of the unexplained 1.3 percentage points drop in participation should be counted as structural. This is because the participation data seem to have been almost wholly impervious to recent fluctuations in the economy.

This elicited a response from Paul Krugman:

So why don’t I believe it? One reason is that I suspect that the apparent downward trend in participation actually reflects differences in how boomy different booms have been. The US economy in 2000 had really, really full employment…. The peak in 2007 was nothing like that. So what looks like a secular downward trend may in large part reflect instead the extent to which the “Bush boom”, such as it was, fell far short of the Clinton boom.

And another from Brad DeLong [do note that this is more me channeling Dean Baker than me being me]:

  • Demographers say that labor force participation should be falling at 0.1%/year due to the aging of the population and 0.1%/year due to increasing wealth and the resulting demand for more schooling and earlier retirement.
  • “Structuralists” say that the recession has given us 15 years of this trend in labor force participation in five as people have changed their life plans in response to the lousy job market.
  • “Structuralists” say that we should not expect a better job market to reverse this acceleration of the demographic trend–because people who have retired early cannot unretire, and once people are expected to have masters degrees to get jobs that used to require bachelors successive cohorts will have no option but to match.
  • Structuralists are wrong:
    • Increasing wealth is not a thing for anyone outside the top 5%.
    • Most of the unemployed young are not building skills but instead are being depressed
    • The over-65 crowd is frantically unretiring as the collapse of their 401k wealth and housing equity has impoverished them….

Incorporating a tolerance of overshooting, after all, was the very point of switching to an Evans Rule last year. Right now, that means a bias in favour of keeping policy appropriately loose. The bias is reinforced by the possibility that the influence of structural factors in the participation rate decline have been exaggerated. What’s the optimal way to keep policy loose? That’s another difficult question…. No matter how strong a new signal on rates guidance, there’s a chance that any tapering decision on Wednesday will be perceived as a tightening. And getting the perception right will matter. As is so often the case with monetary policy, perception quickly becomes reality. The events of May and June should have made this clear.

Within the framework of what’s possible on Wednesday, our own preference thus narrowly remains to both postpone tapering while also using new and more-tolerant guidance, and then waiting for better data…. But the downsides to continued QE aren’t trivial either…