Does QE increase the preference for cash as a way to store wealth?

“we are able to catch a first glimpse of the way in which changes in the quantity of money work their way into the economic system. If, however, we are tempted to assert that money is the drink which stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip. For whilst an increase in the quantity of money may be expected, cet. par., to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money; and whilst a decline in the rate of interest may be expected, cet. par., to increase the volume of investment, this will not happen if the schedule of the marginal efficiency of capital is falling more rapidly than the rate of interest; and whilst an increase in the volume of investment may be expected, cet. par., to increase employment, this may not happen if the propensity to consume is falling off. ” J.M.Keynes 1936

This is my second post about quantitative easing (QE). This subject may seem arcane but I think it is crucial to the general theme of this blog. As I discussed in that previous post, QE is being held out as a painless solution for a stagnant economy. As such, any other policies to sort out our economy get put to one side in favour of giving QE more of a chance. Meanwhile QE seems to have somewhat mysterious effects on asset prices and those impact on inequality and capital flows between countries and so effect us all.

I think it is important to make a clear distinction between simply using QE to bring risk free interest rates down and using excess QE, above and beyond that, in an attempt to satiate any preference the public may have to hold wealth in the form of zero yielding cash rather than as other asset classes such as stocks or bonds. In WWII and its immediate aftermath, the US and UK governments both used QE to peg low interest rates for both short term and longer term government bonds so as to facilitate massive deficit spending. That is a straightforward policy and keeping such low interest rates could be a permanent arrangement much as it has been in Japan for the past couple of decades. However we now have QE being used not so much to facilitate government spending but as an alternative to that as a way to try and stimulate the economy.

In my previous post I tried to rationalize the effects of further QE (once risk free interest rates were at the lower bound) in terms of how it could place a ceiling, for a period, on the extent to which the central bank could subsequently raise interest rates. Nick Edmonds has expressed skepticism as to whether such a constraint would actually come to bear on a central bank that wished to hike interest rates. His point is that, one way or another, a fix would be found.

Nick Edmonds models QE  in terms of how purchases of assets such as government bonds (by the central bank, from the public) induce price changes in all other asset classes, domestic and foreign, as the public rebalances  holdings of those various asset classes. This also tallies with how the Bank of England explains QE effects. To me this raises the crucial issue of why “the public” chooses to exchange other liquid assets for cash* even when cash is a zero yielding asset and the assets they sell do have an appreciable yield. In principle in the simplest model, a liquid asset with ANY yield would be preferable to zero yielding cash that was in excess of what was needed as a medium of exchange. Such a view however overlooks the crucial attribute of cash as the ideal stable store of value over the short and medium term  (1). Perhaps the clearest description I have seen for this is from an interview with Warren Buffett’s biographer Alice Schroeder:-

“”He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.” It is a pretty fundamental insight. Because once an investor looks at cash as an option – in essence, the price of being able to scoop up a bargain when it becomes available – it is less tempting to be bothered by the fact that in the short term, it earns almost nothing. Suddenly, an investor’s asset allocation decisions are not simply between earning nothing in cash and earning something in bonds or stocks. The key question becomes: How much can the cash earn if I have it when I need it to buy other assets that are cheap, versus the upfront cost of holding it? “There’s a perception that Buffett just likes cash and lets cash build up, but that optionality is actually pretty mathematically based, even if he does the math in his head, which he almost always does,””

Asset managers selling assets to the central bank obviously must value the cash they receive just as much as the assets they sell. This undermines the popular narrative about QE causing a “hot potato effect” as asset managers try to offload zero yielding cash. More generally whenever anyone sells an asset to anyone, it is because they value that amount of cash as much as that asset. That, after all, is what sets the market price for assets. So every asset is valued as that amount of “call option …with no expiration date… on every asset class, with no strike price” to use Alice Schroeder’s description of cash in its asset class guise.

Every asset also has its price set by what it itself is likely to earn. Peters and Adamou make the case that asset prices and price volatility find levels at which borrowing money to purchase more of an asset won’t increase gains. Buying more of an asset using borrowed money will amplify any short term gains but also any losses whenever the asset price falls and those losses will outweigh the increased gains overall. This stems from the phenomenon of “volatility decay”. A 25% fall in price requires a 33% rise to get back even,whilst a 50% fall requires a 100% rise. This effect would cap any durable upward repricing of assets unless price volatility also reduced and/or earnings increased.

Obviously, just as cash can be used to “scoop up a bargain when it becomes available“, so any other liquid asset can potentially be sold to fund such a purchase. The asset manager’s ideal would be to have holdings of diverse asset classes that had prices that could be relied upon to move in opposite directions such that bargains in one asset class could be bought when the other asset holdings had boosted available funds. The asset value of cash relies on the unreliability of such negative correlations between the price movements of various assets. I suppose this is making the same general point as J.M.Keynes’s statement :-

“It might be thought that, in the same way, an individual, who believed that the prospective yield of investments will be below what the market is expecting, will have a sufficient reason for holding liquid cash. But this is not the case. He has a sufficient reason for holding cash or debts in preference to equities; but the purchase of debts will be a preferable alternative to holding cash, unless he also believes that the future rate of interest will prove to be higher than the market is supposing.” In this context J.M.Keynes means future interest rates on long term debt or in other words, bond prices.

Of course cash doesn’t simply serve as an asset class; its value is also anchored in the real economy in terms of how much goods and services it can buy. Cash in the hands of asset managers has little influence on the prices of real economy goods and services. Asset managers simply work to transport value through time and use wealth to gather more wealth by buying and selling securities. The cash they control is restricted to that use and so does not generally take part in bidding for goods and services.

So basically the financial system is dealt exogenous constraints from the real economy. Cash has its real economy value and the firms and property underlying assets can only supply asset holders with gains limited by real economic activity. The financial system then juggles that around amongst itself. For everything to still tally up, the extra cash held by the public due to QE must shift the return characteristics of the market to justify the continued exchange of yielding assets for yet more cash. The Peters and Adamou study indicates that increasing levels of cash are unlikely to durably push up asset values. Those selling assets to the central bank also clearly have that perception or presumably they wouldn’t sell. It seems to me that something has to give and perhaps the most likely effect is to synchronize the price movements of the various asset classes. Perhaps that unfolding scenario is the only reason why the public continues to choose to part with assets in exchange for zero yielding cash.

All the cash provided by QE has to be held by someone at all times as with all other issued securities until they are withdrawn. Prior to all of the QE, an upward revaluation of say mining stocks might have entailed a sell off of say long term treasury bonds so as to provide the funds. The last participant to sell his treasury bonds would not have got much money for them and would not have been able to buy many shares of the mining stocks. By contrast, in a post-QE world, the mining stocks could be bid up by buyers who did not need to sell off anything else because they had ample cash reserves to draw upon. Consequently all assets now can be bid up in unison and likewise they can all fall in unison. The more that effect takes hold, the more valuable cash becomes as an asset class. In June 2013 there was a modest drop in asset prices that nevertheless was widely remarked upon because it seemed perfectly synchronized across all major asset classes; all classes of stocks, bonds and commodities, across the globe, seemed to suddenly revalue downwards in terms of the US dollar or Sterling.

Its worth asking whether this is a problem or not. If asset managers now hold more cash and need to hold more cash, then perhaps that is a fairly neutral non-effect. However, at the very least, it makes me very much doubt that we can sort out our economic problems simply by doing more QE.  To me the main downside to QE looks to be a further dislocation between the financial system and the real economy. In an ideal world, asset markets would serve the real economy by coordinating allocation of real resources towards where they could best serve the real economy. I worry that QE might only serve to make asset markets yet more stochastic, disruptive and capricious in their effects on the real economy. Perhaps the starvation that came for many people as a result of the seemingly stochastic spikes in grain prices in 2008 should serve as a warning of the potential real damage irrational financial markets can cause.

notes:

*I’m using “cash” here in the sense of any “cash equivalent” such as risk free bank deposits, very short term treasury bills, and, for banks, bank reserves.

(1) I think Keynes was alluding this when he described the “liquidity-preference due to the speculative motive”. For me however, Keynes’s terminology is unfortunate because this is all about the price stability of cash, not the fact that cash can readily be exchanged for other assets as the adjective “liquidity” is often used to mean.

Related Previous Posts:

Monetary policy, the 1930s and now

Larry Summers at least sees the problem

Related stuff on the web:

Money creation in the modern economy -Bank of England (link added 19march2014 ht JKH)

For Warren Buffett, the cash option is priceless -The Globe and Mail

Chapter 13. The General Theory of the Rate of Interest -J.M.Keynes 1936

Stochastic Market Efficiency -Ole Peters and Alexander Adamou

The Case Against Monetary Stimulus via Asset Purchases -Ashwin Parameswaran

What the *&%! Just Happened -Ben Inker -GMO

Leash the Dogma -John P. Hussman

Investing Like the Harvard and Yale Endowment Funds -Frontier

A Value Investor’s Perspective on Tail Risk Protection: An Ode to the Joy of Cash -James Montier -GMO

Thanks to Dan Kervick and Mark A Sadowski for prompting my thoughts about QE with their astute comments on Steve R Waldman’s Interfluidity blog (obviously if this post is stupid, that’s not their fault 🙂 ).

Monetary policy, the 1930s and now

The US Great Depression of the 1930s still ignites heated controversy, with divergent views as to what was going wrong and how it could have been avoided. Uncanny parallels with some current economic woes emphasise that this is more than just a historical curiosity.

The Great Depression was a very striking phenomenon – a previously thriving economy that had provided the American people with the opportunity to make full use of their talents and the nation’s resources, instead floundered. Although all of the necessary manpower and resources were still immediately to hand, they were left idle and great suffering resulted from the unemployment and lost production. This malaise continued until the start of WWII when the economy was transformed by the massive demand for war equipment with consequent full employment and widespread prosperity.

This 1933 quote from Marriner Eccles exemplifies the underconsumptionist view of what was going on,

“It is utterly impossible, as this country has demonstrated again and again, for the rich to save as much as they have been trying to save, and save anything that is worth saving. They can save idle factories and useless railroad coaches; they can save empty office buildings and closed banks; they can save paper evidences of foreign loans; but as a class they can not save anything that is worth saving, above and beyond the amount that is made profitable by the increase of consumer buying. It is for the interests of the well to do – to protect them from the results of their own folly – that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit. This is not “soaking the rich”; it is saving the rich. Incidentally, it is the only way to assure them the serenity and security which they do not have at the present moment.”

Today, instead, the mainstream view is that the Great Depression could have best been avoided by deployment of monetary policy. Monetary policy has the fantastic attribute that almost everyone finds it politically palatable. It simply involves the central bank making purchases from willing counterparties. If it really can do the trick, then that is fabulous. For just that reason, politicians have been bowled over and have widely abdicated much responsibility for unemployment and price stability over to the central bankers who conduct monetary policy. The problem though is that if monetary policy is incapable of rectifying the problem, then relying on it becomes a dangerous delusion.

According to the monetarist view, the 1930s Great Depression was all down to the phenomenon of monetary deflation. Prices fell but debt burdens and wage contracts were still in place that had been negotiated when prices were higher. Such debts and wage costs  could not be met from the reduced revenue as prices fell. In reaction to that, firms cut costs and directed revenue towards paying down debts. Defaults and bankruptcies caused lenders to become ever more wary of extending credit even to those still seeking it. Unemployment, and the fear of it, reduced consumer spending. That all caused a lack of demand and so further price falls and a destructive deflationary spiral was set off. Proponents of monetary policy claim that it has ample capacity to ward off any such episode.

Such monetary policy consists of central bank purchases of financial assets in exchange for freshly created base money (aka central bank liabilities). If there is a tight shortage of base money (such as was the case in the 1920s and then again in the 1980s) then relieving that shortage can dramatically lower interest rates and so encourage credit expansion throughout the economy. However in the 1930s (as now) there was a glut of monetary base such that interest rates were at the zero lower bound. In fact, Treasury bill rates were actually negative when the Great Depression was at its worst. Prices fell not because there was a shortage of base money overall but because the money was not being used. This was recognised at that time as shown by another 1933 quote from Marriner Eccles,

“In 1929 the high level of prices was supported by a corresponding velocity of credit. The last Federal Reserve Bulletin gives an illuminating picture of this relationship as shown by figures of all member banks. From 1923 to 1925 the turnover of deposits fluctuated from 26 to 32 times per year. From the autumn of 1925 to 1929 the turnover rose to 45 times per year. In 1930, with deposits still increasing, the turnover declined at the year end to 26 times. During the last quarter of 1932 the turnover dropped to 16 times per year. Note that from the high price level of 1929 to the low level of the present this turnover has declined from 45 to 16, or 64 per cent.  I repeat there is plenty of money today to bring about a restoration of prices, but the chief trouble is that it is in the wrong place; it is concentrated in the larger financial centers of the country, the creditor sections, leaving a great portion of the back country, or the debtor sections, drained dry and making it appear that there is a great shortage of money and that it is, therefore, necessary for the Government to print more. This maldistribution of our money supply is the result of the relationship between debtor and creditor sections – just the same as the relation between this as a creditor nation and another nation as a debtor nation – and the development of our industries into vast systems concentrated in the larger centers. During the period of the depression the creditor sections have acted on our system like a great suction pump, drawing a large portion of the available income and deposits in payment of interest, debts, insurance and dividends as well as in the transfer of balances by the larger corporations normally carried throughout the country. The maladjustment referred to must be corrected before there can be the necessary velocity of money. I see no way of correcting this situation except through Government action.”

Nevertheless there is still today a popular view that even when interest rates are essentially zero, further increasing the monetary base nevertheless increases prices. It has to be stressed that this is not about conferring purchasing power to people or institutions who lack it (conferring such benefits would be fiscal policy and not monetary policy). This is about exchanging base money for other liquid financial assets (such as government debt securities) that are worth as much as is being paid for them by the central bank and that can be effortlessly exchanged for money within the private sector anyway. The idea is that somehow the overall quantity of monetary base causes all prices to adjust so as to regain some natural ratio between the monetary value of available goods and services and the quantity of monetary base. Central banks don’t themselves make such a claim but some of the most ardent advocates for monetary policy do. Scott Sumner is perhaps the most strident purveyor of that view.

Scott Sumner acknowledges that the immediate effect of boosting the monetary base is to reduce its “velocity” (the frequency with which each dollar is used). However the claim is that this lack of a short term effect on prices nevertheless projects into a robust effect over the long term. I struggle to comprehend how this short term to long term transformation is supposed to take place. The (hand waving) explanation is that it entails “inflation expectations”. The idea is that for instance employers will keep staff employed, even when the wage bill is too high, in the anticipation that prices will rise enough such that sales and so revenue will cover staff costs. Consequently such high staff costs are actually paid (perhaps funded using extra debt) and the anticipated inflation becomes realised.  So apparently, once interest rates are at the zero lower bound, increases in the monetary base have a purely propaganda role-they supposedly work because they are believed to work. It is claimed that the observed lack of pronounced inflationary impetus from quantitative easing (QE) in Japan, USA and UK is because QE is supposedly expected to be reversed. It is claimed that if people believed QE were permanent, then prices would rise via this “expectations” mechanism.  By that reasoning, this alleged “inflation expectations” mechanism could equally be conducted via some sort of inflationary rain dance. I suspect the fly in the ointment is that people aren’t so gullible and, even when they are, they often are constrained by immediate considerations such as bankruptcy and becoming unemployed.

My view is that QE instead acts to make it harder for the central bank to raise interest rates in the future. The more QE we have, the less likely it is that we have an interest rate rise in the next few years. Currently the Federal Reserve pays interest on reserves so as to prevent interest rates falling below 0.25%. The funds to pay for this come from the interest received by the Federal Reserve on the assets in its own portfolio. Thus the interest paid on reserves cannot exceed the interest received from the assets exchanged for the reserves in the first place. Previous episodes where interest rates have been set high have necessarily relied on a scarcity of monetary base such that banks had to bid against each other to obtain it. From where we are today, such scarcity could be brought about only after the current excess stock had been vastly diminished by government budget surpluses or rendered insignificant by inflation and economic growth. The price impact of any attempt to sell off the Fed’s portfolio of longer maturity assets would thwart any attempt to use such sales to gather back enough of the excess monetary base to induce a scarcity.

A receding risk of future significant interest rate rises does constitute an genuine and rational “expectations” channel BUT it is all about interest rate expectations and not inflation expectations. People may be more willing both to take on more debt and to lend when assured that rates are not going to rise. Central banks have recently offered “forward guidance” saying that they are not going to raise rates for the next year or so. Perhaps QE serves as a demonstrable “bridge burning” exercise that adds considerable heft to such forward guidance. The central bank puts itself into a position where it no longer has any capability to significantly raise interest rates even if it were to want to.

I am not convinced however whether even the certainty of zero-interest rates for decades is really enough to cure an economic depression. To me it looks more like a palliative measure that kicks the can down the road allowing the current imbalances to be perpetuated for a bit longer so debt burdens are serviced rather than defaulting. Debt burdens may be maintained but there is only so much revenue that can be passed through as debt interest if those payments don’t somehow circulate back around from the creditors to the debtors. Expectations of zero interest rates won’t induce such circulation.

Perhaps some of the rationale for the belief in the monetary base setting prices stems from ideas of how the gold standard led to long term price stability. During the gold standard period both in the USA and the UK, prices oscillated but over the long term, inflations were matched by deflations. Subsequently, since leaving the gold standard there has been a steady overall inflation. However the gold standard had its effect by forcing monetary tightening that foreshortened boom periods.  When credit expansion and increased economic activity outgrew the capacity of the monetary base provided by the stock of monetary gold, a tight money recession would lead to debt write downs, fire sales of assets and inventory and a consequent resetting of prices such that the monetary base was once again sufficient. Note that there is a clear mechanism by which insufficient monetary base curtails nominal growth and price rises BUT that is totally different from imagining that adding more monetary base will raise prices when the current stock of monetary base is more than sufficient and yet prices are suppressed due to other constraints.

As mentioned above, in the Great Depression there was a glut of monetary base and interest rates were at the zero bound. The trade surplus between the USA and Europe and the WWI debts that Europe was saddled with had caused a massive transfer of gold from Europe to the USA. That together with the newly created Federal Reserve system, allowed the 1920s boom period to extend for longer than was typical under the gold standard system. Credit growth continued for longer. Eventually debt fueled consumption and speculation could no longer be sustained as funds failed to recirculate from creditors back to debtors and the crash and depression ensued. Perhaps the Great Depression was a manifestation of the more extensive polarisation between debtors and creditors that had built up due to the extended 1920s boom on top of all of the accumulations from the industrial and agricultural developments of the previous century.

Another key assertion from Scott Sumner is that hyperinflations demonstrate that, “Monetary stimulus can make NGDP grow as fast as you like, as we saw in Zimbabwe”. I think it is very misleading to describe such currency slide hyperinflations as being driven by central bank balance sheet expansion. They are typically the result of futile attempts to service unpayable foreign currency denominated debt burdens and in the worst cases also have involved massive supply shocks from loss of production due to political conflict. If bizarrely such a scenario were chosen on purpose, it would not be in the central bank’s power to induce it. The Treasury would need to take on such foreign currency denominated debt and the security services would need to damage productive capacity so as to induce a supply shock. The central bank obviously takes part by way of supplying the ballooning monetary base BUT that is entirely different from claiming that central bank balance sheet expansion provides sufficient cause.

There is however one clear example of monetary policy successfully raising prices during the Great Depression. In 1934 the exchange rate between the US dollar and gold was reset from $20.67 per ounce to $35. That did reset the prices of imports since at that time gold was the unit of account for international trade. It has to be stressed however that after that point in the Great Depression, the fixed  $35 per ounce gold peg acted to limit appreciation of the dollar. If the dollar had been a free floating currency, the price of gold would have fallen in dollar terms as evidenced by the considerable inflows of gold sold to the US Treasury in exchange for dollars. I guess in principle the monetary authorities could have made a commitment to continuously devalue the US dollar against gold by say 10% per year every year. That would obviously have had the primary effect of simply inducing an  impetus to hoard gold. At the time US citizens were prohibited from owning gold so it might instead have acted to induce holding of foreign currency or other stores of value such as other metals, diamonds, art work or land. It would undoubtedly have also instigated a worsening of the international trade disputes and barriers that already bedevilled the period. Perhaps it would have brought forward abandonment of the gold standard by all of the other countries and so rendered the policy impotent. What I am not convinced it could have done is to have shifted spending towards employing and providing for the American people.

I think the crux of this debate revolves around the attempt to shoe horn four contrasting economic conditions of prosperity, inflation, deflation and “tight money” into an overly simplistic model where prosperity is conflated with inflation and deflation is conflated with “tight money”. A simplistic view that sees a straight axis of inflation/prosperity to deflation/“tight money” leads to policy designed to remedy the “tight money” condition being deployed even when there is deflation in the hope that it will be inflationary in the hope that that will cause a shift towards prosperity. In reality many factors need to be in place for prosperity to prevail. Prosperity requires a financial system that supports the wide population in making full use of their talents and property so as to provide whatever is wanted by anyone. It requires a delicate balancing act where financial power is sufficiently distributed to the most competent and yet needs to include the whole of the population such that no one’s potential contribution or needs are left out. Throughout the 1980s and 1990s, many “third world” countries exhibited stalled economic development with mass unemployment and underemployment in conjunction with inflation due to sliding currency values. Wealth polarization with economic exclusion of much of the population and political cronyism will ensure an economic depression irrespective of the inflation level. Tackling those issues is beyond the scope of monetary policy.

Related previous posts

Fiscal autopilot

Bail out the customers not the banks.

Rich people could benefit if everyone else were also rich.

Political Consequences of risk free financial assets

Sustainability of economic growth and debt

direct economic democracy (pdf)

Related stuff on the web:

U.S. Monetary Policy & Financial Markets – Ann-Marie Meulendyke, Federal Reserve (ht Mark A Sadowski)

Testimony of Marriner Eccles at Investigation of Economic Problems 1933

Leash the Dogma -John P. Hussman

Quantitative Easing: Entrance and Exit Strategies- Alan S. Blinder

The United Kingdoms’s quatitative easing policy: design, operation and impact -Joyce, Tong and Woods, Bank of England

Deflation: Making Sure “It” Doesn’t Happen Here -Ben S. Bernanke

The Macroeconomic of the Great Depression: A comparative approach -Ben S. Bernanke

Why (and when) interest-on-reserves matters… -Interfluidity

Some Peculiar Dynamics with Long Term Money Neutrality -Nick Edmonds

1682 days and all’s well -JP Koning

Rates or quantities or both -JP Koning

The Case Against Monetary Stimulus Via Asset Purchases -Ashwin Parameswaran (link added 30nov2013)

A non-monetary explanation for inflation -Matt Busigin (link added 27dec2013)

Money creation in the modern economy-Bank of England (link added 19march2014 ht JKH)