Archive for September 8, 2010

QE2 Beats QT1 Hands Down

September 8, 2010 2 comments

Kocherlakota didn’t drop any bombshells (as an inflation guy I note that his forecast of 1.5%-2% inflation next year represents almost a doubling from current levels and is higher than the market’s 0.9% implied 2011 inflation rate, but the real question is what happens after that), but the Beige Book was surprisingly downbeat. It declared that Fed banks saw “widespread signs of a deceleration,” with home sales “very low” or “declining” in most districts and “sluggish in general” consumer lending.

As I had expected, the markets mostly ignored the Beige Book, and stocks clocked another very low-volume day. However, they racked up gains as investors – I guess – decided that the failure of nations in the periphery of Europe was old news. The S&P gained 0.6% while the 10y Treasury note sold off to 2.65%. (However, the VIX didn’t drop very much even with the stock market back near four-month highs, so there seems to be someone out there who is concerned.) Stories continue to circulate about how European regulators are still finding new documents concerning Greece’s debt. On the other side of Europe, Anglo Irish Bank Corp is to be split into a “good bank” and a “bad bank.”

As an aside: The good bank/bad bank idea seems to have endless traction. It is easy to prove that a company in distress has more value the more entities it splits up into, since each piece can only trade to zero as long as there is limited liability. A portfolio of two options (remember Bob Merton showed that equity can be considered an option on the firm) always has a value equal to or greater than the value of a portfolio consisting of a single option (generally greater…only merely equal if the correlation between the good-pool and bad-pool is exactly 1.0). But that value from splitting one bank into a good/bad bank combo doesn’t come from thin air. It comes from the hides of the debt holders. In the U.S., the debt holders can prevent such a split through litigation, which is why this didn’t happen when it was proposed as a way to save Lehman. I guess that alternative may not be available in Ireland.

After a multi-month respite while Europe went on vacation, it seems that the headlines about Greek debt, problems in Ireland, and the condition of Over There Banks is picking up where it left off after the “stress tests.” Today, investors exhibited a blithe unconcern even though the recent weakening of U.S. growth can certainly not have salutatory effects on the condition of European countries and financial institutions. I may be wrong, because it is unusual to let one’s self be bitten twice by the same dog, but I doubt we have seen the apogee of market concern over the European debt crisis.


Right before our eyes, we are seeing a disturbing trend. Myths about the crisis and the end of the crisis are propagating, only a couple of years after its end. Just today, a commenter on one of my columns[1] implied that monetary easing saved the banks. First of all, it isn’t clear that the banks are saved yet, but to the extent that the risk of imminent collapse of banks receded in late 2008 it was due primarily to the Commercial Paper Funding Facility, when the Fed replaced market financing with direct financing of the banks. That isn’t monetary easing; it is a liquidity backstop.

There is of course the persistent myth that quantitative easing cannot end deflation, because of Japan’s experience in this regard. As I wrote last month (here), this is only because they didn’t really do very much QE. The lesson should be that you need more QE to get inflation, not that it is ineffectual at every dosage.

And there is the myth that loan demand is weak. Perhaps large companies are not demanding loans, because they have had access to the capital markets. But the prevalence of cash on many balance sheets is partly due to the fact that for middle-size companies, traditional cash-management tools like credit revolvers are not available, or only available on onerous terms. Some people misinterpret the improvement in the Fed’s Senior Loan Officer Survey Bank as indicating that credit is ample, but the survey is a measure of the rate of change, not the absolute level of credit supply and demand, and it isn’t surprising that since credit was completely unavailable in late 2008 and early 2009 it is more available now.

The main information we have on credit is the quantity outstanding. The chart below shows that it is still declining, albeit at a shallower pace.

Whether the cause is supply or demand, the quantity of credit is still declining.

This could be because no one wants loans at 0% interest. Or it could be that no one wants to lend money at 0% interest, especially when they just recently had to raise a ton of expensive equity capital and need to buy back the Trust Preferred securities that no longer provide a tax advantage and are therefore expensive. Which do you think is more likely?

It is no longer the case that an individual with a sparkling credit score and a pulse can get a loan – you need more, like a solid job you’ve had for a while or excellent collateral, to get a loan. It is fair to say that in the grand scheme of things, this is an improvement over the time when you needed only a pulse, but again: it isn’t a demand-side issue, it’s a supply side issue.

The books about this period will be written for generations, and some of these myths will die while some of them will propagate. This is a great lesson about history: it isn’t necessarily written by the victors any more, but merely by the people who got to Kindle first. Speaking of which, I expect my book will be ported to the Kindle in the next month or so, but in the meantime you can get a copy pretty cheaply here.

But some of these myths can be damaging in real time. The myth that interest rates should go up to stimulate activity, most-recently propagated by Minneapolis Fed President Kocherlakota, is dangerous because if the Fed follows through on the idea (as Canada did today in raising rates) the outcome will be a disastrous, lengthy depression. Full stop.

It would be no less painful for being ironic if the Fed were to get ahead of the economy, rather than adjusting monetary policy too late, for the first time in decades just when what we need is time for the economy to heal and gather momentum on its own. With thought processes like that floating about, I find myself almost hoping that Initial Claims tomorrow (Consensus: 470k from 472k) is weak. That feels un-American, but while QE2 will likely have bad consequences (notably, inflation) they are ones that we can defend ourselves against. QE2 is vastly preferable to Quantitative Tightening 1.

[1] Make no mistake, I love reading the comments, even ones that disagree with my opinions…it is for the thoughtful feedback that I write this missive every day.

Categories: Uncategorized
%d bloggers like this: