"Beer Goggles", Forward Guidance, Quantitative Easing, and the Risks from Expansionary Monetary Policy: Friday Focus (January 17, 2014)
Dallas Federal Reserve Bank President Richard Fisher: Beer Goggles, Monetary Camels, the Eye of the Needle and the First Law of Holes:
Peter Boockvar, who is among the plethora of analysts... I regularly read... a rather pungent quote from a note he sent out on Jan. 2:
…QE [quantitative easing] puts beer goggles on investors by creating a line of sight where everything looks good…
For those of you unfamiliar with the term “beer goggles,” the Urban Dictionary defines it as “the effect that alcohol… has in rendering a person who one would ordinarily regard as unattractive as… alluring.” This audience might substitute “wine” or “martini” or “margarita” for “beer” to make it more age-appropriate, but the effect is the same: Things often look better when one is under the influence of free-flowing liquidity. This is one reason why William McChesney Martin, the longest-serving Fed chairman in our institution’s 100-year history, famously said that the Fed’s job is to take away the punchbowl just as the party gets going...
I see the argument that ultra-low safe interest rates--loose monetary policy now--or expected ultra-low safe interest rates--loose forward guidance--might, repeat MIGHT induce a "reach for yield" that would involve "beer goggles" in the sense of people who really shouldn't be bearing risks bearing risks.
But I do not see how this argument applies to quantitative easing...
Quantitative easing does not do much to add to liquidity: the long-duration Treasury and GSE bonds the Federal Reserve takes onto its balance sheet are not that much less liquid than the reserve deposits it swaps for them. And because quantitative easing involves the Federal Reserve's buying securities with duration risk in exchange for securities with no duration risk, it reduces the total amount of risk in the marketplace that the private sector needs to bear. Thus I cannot understand why someone would think that quantitative easing--as opposed to loose monetary policy, or loose forward guidance--puts "beer goggles" on assets.
In the financial market there is a demand for risk-bearing capacity by firms and others who want to borrow but who cannot guarantee that they will be able to repay. The higher is the price of risk--the greater the risk premium interest rate spread over short-term Treasuries they must pay--the less they will borrow.
In the financial market there is also a supply of risk-bearing capacity by savers and financial intermediaries who want to lend, and are willing to accept and bear some risk in return from getting more than the short-term Treasury rate. The higher is the price of risk----the greater the risk premium interest rate spread over short-term Treasuries they must pay--the more they will be willing to lend.
When the Federal Reserve undertakes quantitative easing, it enters the market and takes some risk off the table, buying up some of the risky assets issued by the U.S. government and its tame mortgage GSEs and selling safe assets in exchange. The demand curve for risk-bearing capacity seen by the private market thus shifts inward, to the left: a bunch of risky Treasuries and GSEs are no longer out there, as the government is no longer in the business of soaking-up as much of the private-sector's risk-bearing capacity:
And this leftward shift in the net demand to the rest of the market for risk-bearing capacity causes the price of risk to fall, and the quantity of risk-bearing capacity supplied to fall as well. Yes, financial intermediaries that had held Treasuries and thus carried duration risk take some of the cash they received by selling their risky long-term Treasuries to the Fed and go out and buy other risky stuff. But the net effect of quantitative easing is to leave investors and financial intermediaries holding less risky portfolios because they are supplying less risk-bearing capacity.
How do we know that they are holding not more but less risky portfolios? We know because we know that supply curves slope up, and if they were holding more risky portfolios in total--supplying more risk-bearing capacity to the market--the price of risk would have not fallen but risen, and interest rate risk spreads would be not lower but higher, wouldn't they?
So when the intelligent and thoughtful Mark Dow tweets:
I, too, think risks [of QE] overstated, but they're non-zero. Main ones r credit leverage buildup…
I am at a loss. As long as supply curves slope up, QE does not increase but reduces the leverage of private-sector financial asset holders.
And when the intelligent and thoughtful Mark Dow tweets:
I, too, think risks overstated, but they're non-zero. Main ones r… outsized int'l capital flows<
I am again at a loss. Yes, the Federal Reserve has taken some domestic risky assets off the table. Yes, U.S. financial intermediaries and savers will respond by buying foreign assets to so deploy some of their now-undeployed risk bearing capacity. Yes, they will now bear some exchange-rate risk. But, once again, the fact that QE pushes interest rate spreads down is very powerful evidence that these capital flows are not "outsized"--that the extra exchange-rate risk U.S. financial intermediaries have now taken onto their books is less than the duration risk that QE took off of their books.
At least, that is the case as long as the supply curve for risk-bearing capacity slopes up, like a good supply curve should.
Perhaps those who claim that there are big risks to quantitative easing regroup. Perhaps they claim that financial intermediaries are perverted, and that the lower is the price of risk the greater is the amount of risk-bearing capacity they supply to the market because they lose their jobs if they don't make at least three cents on every dollar of assets in a normal year in which risk chickens come home to roost.
In that counterfactual world, the supply-and-demand graph would look like this:
And in that counterfactual world, the Federal Reserve's adoption of quantitative easing policies triggered an enormous expansion of the quantity of risk-bearing capacity demanded by firms and households and a huge private-sector lending boom as firms issued enormous tranches of risky bonds and as firms and households took out risky loans. In that counterfactual world, employment in bond underwriting tripled as $85 billion a month in QE was more-than-offset by an extra $120 billion a month in private-sector bond issues. In that counterfactual world, we saw a rapid recovery of housing construction and a thorough equipment investment boom as far across the U.S. as they eye could see.
That didn't happen.
So what are the risks of QE?
It really seems to be this:
- Commercial banks traditionally accept deposits, put the deposits in long-term Treasuries, rely on the law of large numbers and on deposit insurance to allow them to always hold their long-term Treasuries to maturity, and so have a riskless and profitable business model.
- When commercial banks cannot do this, they find some way to gamble with government-insured deposits.
But this is not a source of systemic risk: because the deposits they may be gambling with are government insured by the FDIC, no run on the banking system or the shadow banking system occurs when risks come due. It would be embarrassing, yes. And the proper response to thinking that commercial banks are running undue risks with government-insured money is to send in the bank examiners--not to undertake policies that raise unemployment.
So put me with Ryan Avent, who tweets:
[The] risk [is that] of not being considered a [very] serious person by peers [unless you claim to greatly fear the risks of quantitative easing]