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Tuesday, March 24, 2009 5:52 AM

Krugman's $200 Billion Lunch

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Paul Krugman frequently proposes solutions straight out of the "free lunch" handbook. However, in one recent case, Krugman actually managed to put a price tag on the lunch. That price is $200 billion.

Please consider Fiscal aspects of quantitative easing (wonkish).

The big policy news [last] week has been the Fed’s decision to buy $1 trillion of long-term bonds, going beyond the normal policy of buying only short-term debt. Good move — but it’s probably worth pointing out that yes, this does expose the Fed, and indirectly the taxpayer, to some risks. And in so doing, it blurs the line between fiscal and monetary policy.

Now, the Fed isn’t taking on any serious default risk.

The Fed is, however, creating a new liability: the monetary base it creates to buy these bonds. In effect, it’s printing $1 trillion of money, and using those funds to buy bonds. Is this inflationary? We hope so! The whole reason for quantitative easing is that normal monetary expansion, printing money to buy short-term debt, has no traction thanks to near-zero rates. Gaining some traction — in effect, having some inflationary effect — is what the policy is all about.

But here’s the rub: if and when the economy recovers, it’s likely that long-term interest rates will rise, especially if the Fed’s current policy is successful in bringing them down. And this also means that selling the bonds at market prices won’t be enough to withdraw all the money now being created.

My back of the envelope calculation looks like this: if the Fed buys $1 trillion of 10-year bonds at 2.5%, and has to sell those bonds in an environment where the market demands a yield to maturity of more than 5%, it will take around a $200 billion loss.

I’m not complaining; I think quantitative easing (it’s really qualitative easing, but I give up on trying to fix the terminology) is the right way to go. But we should go into it with our eyes open.
Fatally Flawed Thinking

I commend Krugman for attempting to put a price tag on his lunch. However, his analysis of the costs and the benefits of that lunch is fatally flawed.

For starters the Fed cannot force long term interest rates down without committing an unlimited amount of purchases, and perhaps not even then. Simply put, the Fed cannot change the primary trend. If long-term interest rates are headed higher there is little the Fed can do about it.

Japan proved that currency manipulation does not work, and I see little reason for open intervention in the treasury market to work either.

Yes, there was a huge treasury rally on the announcement. Was this because of the news or was the market ready to rally anyway? I think the latter. The long bond rallied as did the 10-year treasury, the latter right at a 50% retrace of the move down from mid-October. It was an oversized move but treasuries have sold off three consecutive days since the announcement.

Prices Set At The Margin

Barring short term manipulative disruptions, yields are going to go where they were going to go in the absence of intervention.

Prices of commodities, treasuries, currencies, etc. are set at the margin. And as soon as the massive marginal buyer (the Fed) stops buying, rates will go back to where they were going without the intervention. So committing $1 trillion will not do a damn thing as soon as the money is used up.

Moreover, as long as the Fed is willing to buy assets at inflated prices, there will be an endless supply of sellers. Given enough time and enough dollar commitment, eventually no one would own treasuries but the Fed. Imagine the complications unwinding that.

Fed Can Exaggerate, Not Change The Trend

While the Fed cannot change the trend, it can exaggerate it. Thus if interest rates are not ready to go down on their own accord, attempts to force them down will fail, but unwinding them might cause a bigger problem than Krugman thinks.

Does Quantitative Easing Even Work?

For the sake of argument let's assume by some miracle the Fed can force down rates to where they would not go on their own accord. Would that stimulate anything?

To answer that question let's turn to Japanese Lessons.
“The [Japanese] central bank's implementation of quantitative easing at a time of zero interest rates was similar to a shopkeeper who, unable to sell more than 100 apples a day at Y100 each, tries stocking his shelves with 1,000 apples, and when that has no effect, adds another 1,000. As long as the price remains the same, there is no reason consumer behaviour should change – sales will remain stuck about 100 even if the shopkeeper puts 3,000 apples on display. This is essentially the story of quantitative easing, which not only failed to bring about economic recovery, but also failed to stop asset prices from falling well into 2003.”

- Richard Koo, "The Holy Grail of Macro Economics: Lessons from Japan's Great Recession" (John Wiley 2008).

Richard Koo is particularly good at pointing out that the monetarist Emperor has no clothes. Cutting interest rates to zero in post-bubble Japan had little impact because in a balance sheet recession, when companies are determined to pay down debt to stay alive, they will not borrow at any price.

In Koo‟s words, “Quantitative easing was the twenty-first century's greatest monetary non-event.”

When your investment case essentially rests on nothing more substantial than "greater fool theory" and a somewhat magical process whereby the Treasury issues debt which is immediately bought back by the central bank, it is probably time to look to a less heavily manipulated market.

On the likely impact of quantitative easing in the UK, Richard Koo again:

“At the risk of belabouring the obvious, imagine a patient in the hospital who takes a drug prescribed by her doctor, but does not react as the doctor expected and, more importantly, does not get better. When she reports back to the doctor, he tells her to double the dosage. But this does not help either. So he orders her to take four times, eight times, and finally a hundred times the original dosage. All to no avail. Under these circumstances, any normal human being would come to the conclusion that the doctor's original diagnosis was wrong, and that the patient suffered from a different disease. But today's macroeconomics assumes that private sector firms are maximizing profits at all times, meaning that given a low enough interest rate, they should be willing to borrow money to invest.

In reality, however, borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan's Great Recession.”
Krugman might counter that forcing long-term rates down will lower rates on mortgages. It will do no such thing. Mortgage rates long ago disconnected from the 10-year treasury, primarily because of rising default risk. This is why the Fed has a separate facility dealing specifically with mortgage rates.

Given all the Fed and Fed-sponsored lending facilities, the Fed is pretty much the lender of only resort across the board. In this case, if you were a bank would you want to commit to holding a 30 year mortgage when the only reason rates were low was because the Fed manipulated them that low (assuming once again the Fed could do such a thing)?

In Passing the Buck economist Greg Mankiw was the one arguing for quantitative easing while challenging Krugman who argued for deficit spending. This caused a bit of a spat at the time and they have been arguing about many things ever since .

For the record, both are now wrong because quantitative easing did not accomplish a damn thing for Japan nor will it accomplish a damn thing for the US. What it will do however, is distort the economic picture while creating an expense unwinding something that should never have been wound up in the first place.

Moreover, Krugman is doubly wrong because of his Keynesian "hangover theories" as noted in Krugman Still Wrong After All These Years.

At least we have a price tag for this lunch proposal. It's a start. Now all we need is for Krugman to come to the realization that the benefits are negative. After all, $200 billion lunches that provide no benefit are rather expensive indeed.

Mike "Mish" Shedlock
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