Thursday, January 10, 2013

Pay Attention to the Bond Market

Here, George Melloan explains in clear terms how economic reality will have its day, notwithstanding the machinations of politicians.  Dare I repeat an old message in this blog?  "You can't borrow what hasn't already been produced and saved."


3 comments:

DLK said...

Extracted from the WSJ, here are interesting and enlightening comments to Mr. Melloan's original article.

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In "Deficits, Debt and the Fate of the Dollar" (op-ed, Jan. 10), George Melloan notes many concerns about the future course of the bond market, inflation and the value of the U.S. dollar. He appears especially concerned with the Federal Reserve's "present course of buying up more hundreds of billions of Treasury paper. That course inevitably leads to inflation."

Quantitative easing (QE) is an attempt by the Fed to lower long-term interest rates which, as Mr. Melloan correctly points out, hasn't been successful very recently. However, despite widespread belief to the contrary, QE isn't inflationary. QE is, in effect, simply an asset swap. The banks receive the reserves and lose the bonds, with no net change occurring to the asset side of the banking system's balance sheet. That is, the private sector's financial assets are unchanged. In addition, since the bonds yield more than the reserves, the private sector experiences a net loss of income from the direct effects of QE.

Furthermore, while reserves for the banks have increased, this change doesn't impact the potential for money-supply growth caused by an increase in the volume of loans. Loan volume is a function of the demand for loans, credit standards and the resulting number of credit-worthy borrowers. This demand has no relationship with bank reserves.
It should be no surprise that past QEs have not resulted in higher inflation. The current QE3 activity will have the same inconsequential impact on inflation rates.

Charles DuBois

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This is nonsense. Let's say the Treasury issues $100 million in bonds in a "normal' environment. In that case, private sector investors will take their cash and use it to buy the bonds and now the government has $100 million to spend while the previous holders of the money just have the bonds. In QE, though, the Fed prints (electronically creates) a brand new $100 million to buy those bonds so now the government has $100 million to spend while the private sector STILL has its own $100 million to spend elsewhere. In other words, under QE there's an additional $100 million in money created, and that *is* inflationary.

Mark B. Spiegel

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Mr. Spiegel is quite correct. I would add that QE has not yet been inflationary because it has not worked in driving economic growth. When Fed easing policy "works" , the Fed injects money into the banking system (as QE does)...but the next successful and required step is the banks make loans, usually more loans than the amount of money the Fed itself injected. Not until the loans are made is the economy stimulated. But this is also when the inflation occurs. The loan process is what actually injects the Fed's money into the real economy. Until then, the Fed's money simply sits in a bank account known as excess reserves. As the money enters the economy we can find that too much money is chasing too few goods...the classic definition of inflation.

Today we find the world in debt. The dominant and defining economic event of the next ten years is paying down debt at all levels. This is called deleveraging. It is a lengthly, painful but necessary process. The Federal Reserve wants the world to take on more debt but the world is swimming in the other direction. This is an important part of why the massive QE program has so far failed in meeting its objective.

Charles Jones

Fiddlinmike said...

Thanks again for the excellent posts. I had to “Google” the WSJ article because I am not a WSJ subscriber.

I’ll admit up front that I’m not an economist. I have to break things down in simple terms.

In the response to the WSJ editorial, Mr. Dubois makes one very good point about what drives economic activity, but I think he misses in trying to convince folks that QE doesn't lead to price inflation.

Before I elaborate on the above, I don’t see how Mr. Dubois can justify the statement that QE hasn’t been working lately to keep interest rates low. What has been keeping interest rates near 0% for so long? (Part of any economic discussion must be defining terms like “lately”). It seems to me the FED is doing a great job of keeping interest rates low. They think this is simulative. I think it's economic manipulation on the largest possible scale. It discourages savings and encourages over-consumption and mal-investment. What works “lately” can be horrible “later.”

Back to QE: My simple non-economist analogy for Mr. Dubois' message is as follows… Under QE, the FED buys a $100 treasury bond from Bank A. Now Bank A has $100 cash (really just a credit on the FED’s books) instead of the Treasury bond. According to Bank A’s balance sheet, they’ve just made an equal exchange, cash for a bond. So there’s no difference to the bank's or the “private sector’s financial assets”– it’s just an “asset swap” . But, of course, the FED had to “create” the $100 to purchase the bond (I still like to call it “printing” it because it helps me stay pissed off).

Sidetrack Warning: Mr. Dubois then states that the $100 bond was more valuable to the bank than the $100 deposit at the FED (in terms of future income) so the public market has less income as a consequence of the transaction. I don’t follow that. If that’s true, it's not a pure asset swap, and why would any rational bank trade for lower economic value? It’s a small point that I’ll overlook because it’s not his primary thesis.

Continuing...Now Bank A has an extra $100 in “cash” sitting at the FED and is out one $100 bond. Mr. Dubois rightfully points out that this event hasn’t created any new investment projects, or new credit-worthy entrepreneurs with ideas. There’s just more “cash” sitting out there in the financial world that is never to be used – so it’s not inflationary at all (at least not "lately").

Well, I love the point that it’s human interaction in markets that creates economic value, not making up “money.” But in the long run this is clearly inflationary. In the BEST case, this money eventualy finds it's way into the private market through mal-investment of "cheap" money.

“Inflation” happened the day they did the QE. The effect of this inflation is yet to be seen, but it will be seen.

I have a friend (who apparently watches too much MSNBC) who said that he was tired of all the “big banks” holding onto piles of cash. He thought it would be appropriate for the government to force them to loan it out. How long will it take for that idea to become popular in the media and to the masses? Yes, let’s force those greedy banks to put money in solar panels or cable cars, maybe build a pyramid for Keynes. That'll help everyone. We'll create jobs, and make the world more fair.

I’m not ready to disconnect QE and inflation. The argument that Mr. Dubois makes is too sophisitcated for joe-sixpack and suffers from short term thinking.

Thoughtful folks are going to need to retain the argument that printing money increases prices as the best counter to the argument that greedy corporations are charging too much for their products, which will be the popular view.

Mike Brown

DLK said...

You are right, of course, Mike. Mr. DuBois is completely off his rails, as Mr. Spiegel and Mr. Jones observe.